David Randall and Davide Barbuscia, SaqibIqbal Ahmed

NEW YORK (Reuters] – Parts of the U.S. Treasury yield curve have been inverting and has flattened as investors consider an aggressive rate-hiking program by Federal Reserve to reduce inflation from highs 40 years ago.

This has caused investors to speculate about whether this signals a near-term recession.

Investors pay attention to the shape of the yield curve. It influences asset prices and feeds into bank returns. This is an important indicator of economic health. Recent Fed moves reflect investor concerns about how tightening monetary policy can be done to restrain inflation but not hurt economic growth.

Parts of the yield curve are used by investors as indicators for recession. These include the spread between yields on Treasury bills three months and 10 year notes, and U.S. 2-year-to-10-year curves. These two yield curves have diverged in different directions and there is some uncertainty about how reliable they give a recession signal.

Some other parts of this curve are less well-observed. For example, the spread between the five-year and the 30-year Treasuries inverted Monday. This has happened before in some recessions.

Let’s start by explaining the meaning of a yield curve that is steep, flat, or inverted. We will also discuss how this has been used to predict recessions in the past and its potential implications for now.

What SHOULD A CURVE LOOKS LIKE?

U.S. Treasury is responsible for financing federal government budget obligations through the issuing of various types of debt. The $23 trillion https://fred.stlouisfed.org/series/MVMTD027MNFRBDAL Treasury market includes Treasury bills with maturities from one month out to one year, notes from two years to 10 years, as well as 20- and 30-year bonds.

The yield curve represents the yield on all Treasury securities.

Because investors assume more risk from rising inflation, the curve will tend to be upwardly sloped. Because a 10-year bond has a longer term, it typically yields higher than a 2-year one. The yields are related to the prices.

A steepening curve is indicative of higher expectations for stronger economic activity, greater inflation and higher interest rate. Flattening can signify the reverse: Investors may expect rates to rise in the short term, and they have lost faith in the economy’s future growth prospects.

WHAT IS AN INVERTED CURRVE?

The U.S. curve has inverted before each recession since 1955, with a recession following between six and 24 months, according to a 2018 report https://www.frbsf.org/economic-research/publications/economic-letter/2018/march/economic-forecasts-with-yield-curve by researchers at the Federal Reserve Bank of San Francisco. Only once did it give a false signal.

In 2019, the 2/10 portion of the yield curve was reversed for the last time. In 2019, the 2/10 part of the yield curve was inverted. The United States went into recession the following year, albeit due to the pandemic.

WHY IS THEYIELD CURVE INVERTING?

Short-term yields on U.S. government bonds have been increasing rapidly this year in anticipation of several rate rises by the U.S. Federal Reserve. However, longer-dated bond yields have increased at a slower pace due to concerns that policy tightening could harm the economy.

The Treasury yield curve is therefore generally flattening, and sometimes inverting.

Flatter by the month – US yield curve https://fingfx.thomsonreuters.com/gfx/mkt/mypmnqkdnvr/Pasted%20image%201648502812707.png

The yield curve was inverted by last week for parts, five to 10, and three- to 10-years.

According to data from Refinitiv, the spread between U.S. Treasury yields of five-year and 30-year maturities fell as low as minus seven basis points (bps) on Monday. This was below zero for only the second time since February 2006.

This spread is now negative 53 bps as of the start this month. The spread of 5/30 years was inverted before the 2008-09 and 2001 recessions, but not after the 2020 pandemic.

Yield curve inversions and recessions, 5-yr/30-yr curve https://fingfx.thomsonreuters.com/gfx/mkt/zjpqkdwzxpx/Pasted%20image%201648486055821.png

According to Refinitiv data, the overnight index swaps OIS market saw the yield curve for two- and 10-year swap rates reversed. It was inverted for only the second time since late 2019.

The curve has two parts that are especially important to be watched. One is the gap between the yields of two-and. This gap, which widely predicted a recession when the inverts, is closely monitored. This spread stood at 12.1 base points, down from 24 basis points 10 jours ago.

ARE WE GETTING MIXED SIGNALS?

Yet, another part of this curve is still being closely monitored has been sending out a signal. This month, the spread between the yields on 10-year and three-month Treasury notes has been growing, leading to some people doubting that a recession will be imminent.

Yield curve inversions and recessions, 3-mo/10-yr curve https://fingfx.thomsonreuters.com/gfx/mkt/gkplgqdrwvb/Pasted%20image%201648503037022.png

There are technical difficulties with the 2-year/10-year yield curve, which is why not all people believe the flattening curve to be telling the whole story. According to them, the Fed’s bond-buying program over the past two years has led to a U.S. 10-year yield undervalued that will increase when it shrinks its balance sheet and steepens the curve.

The benchmark U.S. 10-year yields rose above 2.5% to 2.55% Monday. This was their highest level since April 2019. They topped the 2 % mark for the first-time since 2019 in February.

Yield curve inversions and recessions, 2-yr/10-yr curve https://fingfx.thomsonreuters.com/gfx/mkt/dwvkrqebxpm/Pasted%20image%201648485936956.png

Researchers at the Fed, meanwhile, put out a paper https://www.federalreserve.gov/econres/notes/feds-notes/dont-fear-the-yield-curve-reprise-20220325.htm on March 25 that suggested the predictive power of the spreads between 2 and 10-year Treasuries to signal a coming recession is “probably spurious,” and suggested a better herald of a coming economic slowdown is the spread of Treasuries with maturities of less than 2 years.

HOW DOES IT APPEAR IN THE REAL WORLD

Rate increases are a tool to fight inflation but they can also be used as a tool for slowing economic growth, increasing borrowing costs from cars and mortgages to pay them back.

Apart from the signals it can flash on the economy’s health, the shape and direction of the yield curve have ramifications both for business and consumers.

U.S. banks increase their benchmark rates when short-term interest rates rise. This can lead to higher borrowing costs for Americans. The mortgage rate also goes up.

Banks can borrow money at lower interest rates while lending at higher rates when the yield curve is steeper. In contrast, banks may find that their margins are squeezed when the yield curve is flat. This could discourage lending.