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Bonds flash recession warning light as key part of the yield curve inverts again

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Bonds flash recession warning light as key part of the yield curve inverts again

According to a closely watched measure, the bond market is sounding the alarm that the economy may be slipping or has slipped into a recession.

Market professionals focus on the spread on the U.S. Treasury yield curve, or the difference between long-term Treasury yields and short-term Treasury yields. Typically, yields on longer maturities, such as 10-year bonds, are higher than yields on shorter maturities, such as 2-year bonds. But the 2-year Treasury yield is now higher than the 10-year yield.

The 2-year U.S. Treasury note was yielding 2.792% as of midday Tuesday, above the 10-year yield of 2.789%. You can monitor this key propagation in real time here.

This so-called reversal is a warning sign that the economy may be weakening and a recession is likely.

“Given that the 10-year yield is reversing below 3%, there’s something hard to ignore going on in investor sentiment,” said Ian Lyngen, head of U.S. rates strategy at BMO. “I wouldn’t say it’s a direct indicator of the economy. A recession is a near-term risk. Rather, this is consistent with heightened fears of a recession.”

One way to look at the importance of the yield curve is to consider what it means for banks. The yield curve measures the spread between a bank’s cost of money and what it earns by lending or investing over a longer period of time. If banks can’t make money, lending slows and economic activity slows.

After surging to nearly 3.5% in mid-June, the 10-year yield has fallen to 2.78% and hovers just below the 2-year yield of 2.79%. The 10-year Treasury note moved higher on inflation concerns, but reversed as investors worried about the economy. Yields move in the opposite direction of bond prices.

The 10-year benchmark rate is widely watched because it affects mortgage and other lending rates. 2 years were more affected by Fed rate hikes and have been moving higher.

“I didn’t know it was a recession indicator in itself,” said Gregory Faranello, head of U.S. rates at AmeriVet Securities. “For the Fed, there’s a battle going on between inflation and growth. My view is that inflation is still higher than growth.”

The 2-year to 10-year curve first inverted on March 31, then briefly reversed again in June. Faranello also noted that the curve inverted in 2019, warning of a recession. But since the Fed was cutting rates at the time, he said a recession in 2020 might not have happened if it weren’t for the pandemic.

To be sure, some investors and economists typically want to see this inversion persist for a long time before believing it heralds a recession.

Markets have grown more fearful of the possibility of a recession in the past few weeks. Economic data was weak, with Federal Reserve Chairman Jerome Powell saying the central bank would be steadfast in its fight against inflation. Investors are increasingly worried that the Federal Reserve will raise interest rates sharply, slowing the economy to the point of recession.

Despite the market’s growing concerns, many Wall Street economists don’t expect a recession this year, although some predict the economy could enter a contraction next year.

Powell was recently asked about the possibility of an inverted yield curve, Faranello said. “His response was: ‘We’re not worried about that right now. We’re worried about getting inflation down to 2 percent.’ It’s definitely inflation outpacing growth, and the Fed isn’t worried about an inverted yield curve,” Faranello said.

In addition to the weak data, investors also focused on the Atlanta Fed’s GDPNow indicator, which forecasts a 2.1% contraction in gross domestic product in the second quarter. Predictions are based on incoming data. If the second quarter does contract, it will be the second consecutive negative quarter, which is technically considered a recession.

“The closer it is to the actual print, the more credible it is, because it’s cumulative,” Lingan said. Growth contracted 1.6% in the first quarter.

According to Bespoke, when the yield curve inverts, “there is a more than two-thirds chance of a recession at some point in the next year and a more than 98 percent chance of a recession at some point in the next two years.”

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