The U.S. Treasury yield curve is flashing a warning sign to Wall Street, where many are worried that a recession could be in store after bond investors pushed up short-term rates to the point where yields on the two-year Treasury were actually higher than the 10-year Treasury.
Such a phenomenon, called a "yield curve inversion," is a key metric that investors watch as bond yields impact other asset prices, feed through to banks' returns and have been an indicator of how the economy will fare. Aside from signals it may flash on the economy, the shape of the yield curve has ramifications for consumers and business.
On Tuesday, one of the most closely watched parts of the curve, the two-year to 10-year curve, inverted, after weeks of sharp moves in the U.S. Treasury market, where investors have sold off Treasuries anticipating aggressive interest rate hikes from the U.S. Federal Reserve which is fighting surging inflation.
That has sent a warning sign for investors that a recession could follow. The last time it inverted was 2019 and the following year, the United States entered a recession - albeit one caused by the global pandemic.
"A lot of people focus on this and there could be a self-fulfilling expectation, they see the 10 year/2 year invert and believe there will be a recession and change behavior," said Campbell Harvey, professor of finance at the Fuqua School of Business, Duke University, who pioneered using the yield curve as a predictive tool for recessions. "So if you're a company you cut back capex and employment plans."
Harvey, who focused his research on a different part of the yield curve, added that being prepared for a recession was "not a bad thing... so when it occurs you survive."
Broker/dealer LPL Financial said the 2/10 inversion is "a powerful indicator" pointing out that it predated all six recessions since 1978, with just one false positive.
According to Anu Gaggar, global investment strategist for Commonwealth Financial Network, the lag between curve inversion and the start of a recession has averaged about 22 months but has ranged from 6 to 36 months for the last six recessions.
Some investors caution that the yield curve is just one indicator among many to look for when predicting recession. Indeed, equity markets have shot higher in recent weeks, with the S&P 500 cutting its year-to-date loss to around 3% after confirming it was in a correction last month.
For many market participants, however, the curve has become a classically followed signal.
“There is definitely a psychological element to it,” said Gennadiy Goldberg, senior rates strategist at TD Securities. "The yield curve has worked in the past because it has been a signal that the end of the cycle is coming.”
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