As this spread narrows, investors fear that the yield curve could eventually invert, meaning that short-term rates will be higher than long-term yields. As of Friday, the difference was only 0.25%, with 10-year bonds yielding about 2% and 2-year bonds yielding 1.75%.
The gap widened slightly on Monday as the 10-year yield climbed to 2.1% and the 2-year yield rose to around 1.82%, resulting in a spread of 0.28%.
An inverted yield curve has often been a potential recession signal. The yield curve flipped in 2019 ahead of the 2020 Covid-induced recession. This was also done in 2007 before the 2008 Global Financial Crisis/Great Recession. And that all changed in early 2000, right before the dot-com and tech stock crash.
U.S. Labor Secretary Marty Walsh told CNN’s Poppy Harlow that the recession is “real” but added that “we have a very strong economy” and noted that the labor market in particular is healthy.
When investors want higher short-term bond rates, it’s an indication that bondholders are nervous. Typically, long-term bond rates are higher because you have to wait longer to receive payments.
So, how much should investors worry about the yield curve flipping over?
Some argue that the only reason this is happening is Russia’s invasion of Ukraine and the resulting spike in commodity prices.
“Recession risks are rising, but not necessarily immediately, unless global geopolitics deteriorates sharply from this delicate starting point,” Jim Reed, strategist at Deutsche Bank, said in the report.
The Federal Reserve, widely expected to raise interest rates later this week, may be careful not to raise rates aggressively enough to push short-term yields even further and eventually flip the yield curve.
This could lead to a downturn in the labor market. And the Fed should keep an eye on the unemployment rate as well as inflation.
“Chair [Jerome] Powell will make it clear that the Fed is aware of its dual mandate and does not want to invert the yield curve and cause a recession,” ICAP Chief Investment Officer Jay Hatfield said in the report.
Inflationary fears existed before Russian-Ukrainian relations
While geopolitical tensions may have distorted prices, inflationary pressures were mounting even before Russia’s attack on Ukraine.
“Russia/Ukraine is only adding to the natural economic slowdown that could have occurred when the Fed tightened policy,” Tom Essay, founder of Sevens Report Research, said in a note last week.
Essay argues that the Fed’s rate hike and economic slowdown would likely have resulted in an inverted yield curve at some point later this year, even if Russia and Ukraine weren’t in the headlines.
“The impending rate hike (which is still happening) will be coupled with slower growth momentum from higher commodity prices and higher inflation, leading to an earlier-than-expected slowdown in growth,” he said.
Rising short-term rates could also create problems for large Wall Street firms. While higher rates tend to increase returns on loans, they also make trading, especially bonds, a gamble.
“The recent flattening of the yield curve and volatility in the capital markets represent new risks, so we are more cautious on the largest banks,” analysts at research firm KBW said in a recent report.
The fact that bond yields are low is not necessarily a bad thing. Rates fall when investors buy bonds. Thus, traders clearly still view US Treasury debt as stable enough to continue to flock to it. But such a sharp drop in short-term rates is unusual.
One strategist noted that it doesn’t matter if investors buy bonds because they consider them safe. There is more to worry about.
“The drumbeat of the recession is picking up steam,” Nancy Tengler, CEO and CIO of Laffer Tengler Investments, said in the report. “Of course, there are many reasons for concern. Soaring inflation, rising energy prices, a near-certain eurozone recession and a dangerously flat yield curve.”
“It doesn’t matter that the yield curve is skewed by the exodus towards quality,” Tengler added. “Inversion is inversion.”