These Are Not The Recession Signals You’re Looking For

These are not the recession signals you’re looking for

Over the last 40 years the US economy has slipped into recession 6 times. During those 40 years, the difference between 10y yields and 2y yields (2s10s curve) has reliably dipped into negative territory on average about 18m before GDP turns negative (Chart 1). Today the 2s10s curve is once again knocking on the door of becoming inverted (while some curves like the 3s10s and 5s10s already are), causing quite a stir among market watchers that recession is imminent. Though certainly growth may slow as the Fed tries to rein in inflation, our work suggests investors will be better served looking elsewhere for recession signals. In fact, our models show the flatness of the curve could be more a consequence of the Fed’s relentless buying of bonds, and the consequent growth of their balance sheet, rather than because of a looming growth shock. As such, the true fair value of the 2s10s spread could be in the 150bp-200bp range had the Fed never engaged in its multiple rounds of quantitative easing.

Up, down, all around…

The trick with looking at interest rates curves is that investors need to account for two variables: The short end of the curve (the 2y note) and the long end of the curve (the 10y note). Though perhaps obvious, it’s important to highlight that curve flattening can be a function of any combination of directional moves in yield as long as the 2y is increasing by more (decreasing by less) than the 10y.

Depending on how the curve flattens, and why, could make a difference in determining whether the signal it is sending today is the canary in the coal mine, or conversely, nothing but noise.