Yield curve inversion: a harbinger of recession amid Fed tightening

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Editor’s note: Jimmy Zhu is chief strategist at Fullerton Research. The article reflects the opinion of the author, and not necessarily the views of CGTN.

A man works near the New York Stock Exchange on March 11, 2022 in New York, New York, US / CFP

A man works near the New York Stock Exchange on March 11, 2022 in New York, New York, US / CFP

The inverted yield curve in the United States means that yields on shorter-term bonds are higher than those on longer-term bonds. It can be three months versus 10 years, two years versus 10 years, or 10 years versus 30 years. Among them, the two-year and 10-year government bond yields are the most watched, as the inverted yield curve has accurately predicted the next recession over the past decades.

Earlier this week, the yield on two-year U.S. government bonds was higher than the 10-year rate for the first time since 2019, reminding many Wall Street participants that recession risk should not be ignored.

Over the past five decades, the reversal in US 2/10-year government bond yields has occurred approximately seven times (in 1978, 1980, 1988, 1998, 2000, 2006, and 2019), followed each times of an economic recession, such as the famous Recession of the 1980s and the global financial crisis in 2008.

After the 2/10 year curve inversion this time, not everyone is convinced that the largest economy is facing another recession. Some of the investors argued that the US economy could have avoided the 2020 recession if COVID-19 had not been affected. However, it is worth mentioning that the trade tensions between the United States and China at that time had already considerably weakened the activities of American factories and consumer sentiment.

When the 2/10-year bond curve inverted in August 2019, the US IMS manufacturing PMI was at 48.5, well below the 50 threshold line and almost the lowest since 2015. The confidence index of consumers was also at its lowest since 2016 at that time. Although the Fed began cutting the benchmark lending rate in July of that year, economic activity did not improve much towards the end of 2019.

That said, it could be another “unexpected” event that pushed the US economy into recession at some point, even though COVID-19 never existed. When the yield curve inversion appears, commercial banks are less willing to lend because their profit margin decreases. These short-term bond yields are generally tracked by deposit rates, and bank lending rates tend to track longer-term yields like 10-year and 30-year rates.

Thus, the inversion of the yield curve significantly reduces the interest rate margin of commercial banks, even below zero. As a result, these banks would be less willing to lend, which slows down economic activities. Data shows commercial and industrial lending by U.S. commercial banks slowed in the second half of 2019 as the bond yield curve flattened and inverted, following a strong rally in 2018.

No better choice for the Fed

The US economic outlook depicted by the bond yield curve could be correct, even if the risk of recession is not imminent. In the past, the inverted yield curve encouraged the Fed to ease monetary policy to rein in short-term rates, like it did in 2019. But the current escalation in inflation has forced the Fed to continue to accelerate the pace of tightening, a move that can only deteriorate the currently fragile US economy.

However, slowing inflation has already become the Fed’s top priority. Rising inflation has significantly weakened US consumer confidence, with the University of Michigan Consumer Confidence Index falling to its lowest level since the 2008 global financial crisis. chance that the Fed could raise rates by 50 basis points at the May meeting.

Fed Governor Lael Brainard, who is considered a dovish member, said on Tuesday that the Federal Open Market Committee (FOMC) would continue to methodically tighten monetary policy through a series of interest rate hikes and beginning to reduce the balance sheet at a rapid pace. from the May meeting.

Hawkish statements made by Fed members are likely to increase financial market volatility as investors favor safe-haven assets like US government debt. Among these bonds, long-term government bonds could see rising inflows, and such an outcome could push the 10-year yield lower, while the short-term yield could jump amid higher policy rates.

The Fed’s ability to engineer a soft landing for the US economy largely depends on how quickly it can resolve the inflation problem. While commodity prices may continue to rise amid ongoing disputes between Russia and Ukraine, the Fed may have no choice but to continue to tighten policy to rein in demand. Thus, this could lead to a further recession in the US economy as early as 2023.


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