By Amanda Agati, EVP and Chief Investment Officer, PNC Financial Services Group, Inc.
There’s been a lot of attention on the yield curve lately, so I thought it would be timely to set the record straight on what’s going on with the yield curve and why it matters for investors.
In traditional business cycle analysis, a leading indicator of recessions is, in fact, the shape of the yield curve. When portions invert or look kinked as depicted by the light blue line in Chart 1, instead of a smoothly upward sloping curve as depicted by the light gray line, that is usually the bond market signaling some cause for concern in the economic outlook. An inverted yield curve means longer-dated maturities are yielding less than shorter-dated maturities – and that is counterintuitive – investors expect to get paid in the form of higher interest rates over longer horizons.
So, let’s zoom in and take a closer look at two sections of the yield curve – the 2-year to 10-year Treasury yield spread and the 3-month (Federal Funds rate) to the 10-year Treasury yield. These two spreads have historically been highly correlated (0.90), which means they tend to move together in similar patterns over time, but not perfectly in sync with each other. Consider Chart 2, however, which compares the paths of these two spreads. They are moving in sharply opposite directions lately and, as a result, they’re definitely giving us mixed signals in terms of the potential path forward. So, perhaps it’s not entirely surprising that the “R” word (that is, recession) is being discussed much more frequently lately, especially with all of the volatility in the market, the Federal Reserve signaling the need to do seven more rate hikes this year and now the unusual shape of the yield curve and spread divergences.
Notably though, the one spread that tends to be the primary “canary in the coal mine” recessionary signal is actually the 3-month to 10-year Treasury yield. The 3-month to 10-year depicted by the orange line in Chart 2 is sitting at about +185 basis points (bps), which means it is far from being inverted, is normally shaped, and, in our view, is the market signaling there is still ample runway left in this cycle despite a likely much slower pace of economic growth ahead. However, the 2-year to 10-year depicted by the dark blue line in Chart 2 is now sitting at about -5 bps, meaning the yield on the 2-year Treasury is actually above the 10-year Treasury, and has inverted, as of this writing. This portion of the curve is telling a decidedly different story, in our view. It’s the market signaling the Federal Reserve is potentially too far behind the curve in tamping down inflation and will have to be very aggressive in playing catch-up – translation: the Federal Reserve could tighten policy so much that it tips the U.S. economy into recession. Investors beware!
While we are obviously watching this signal very closely, so is the Federal Reserve. We think calls for recession based solely on the inversion in the 2-year to 10-year yield are just too premature. It is a useful tool in the proverbial toolbox for our business cycle analysis, but it is not a perfect indicator. Even when it is correct in forecasting an economic recession, the market peak is typically well beyond a year after the initial yield curve inversion occurs. There is still time left on the clock and financial conditions are still in supportive territory for markets and the economy.
Amanda Agati is the Chief Investment Officer of PNC Bank, N.A. The views expressed are those of the author and are not necessarily those of PNC Bank.