Prices may be facts but interpreting them is always difficult. Nowhere is this more evident than in recent movements in the market for US Treasuries. As the pre-eminent safe assets that investors use to ride out, changes in their price are uncertain over for signs of how investors feel about the general economic outlook. The yield curve — the difference in returns available to investors depending on the maturity of government debt — has demonstrated particular predictive powers over the timing of recessions.
Worryingly, it has been heading towards “inversion”, a state in which the interest rate on long-dated debt is lower than that on shorter-dated debt. Such a deviation from the norm has heralded every single US recession since the 1970s — even the most recent one provoked by the coronavirus pandemic. The prospect of inversion comes on the back of a tumultuous time for bond markets: the US Treasuries market looks set to have its worst month since 2016 on the back of accelerated selling of both short and long-dated debt.
Forecasting the pandemic may have been a fluke but the usual rationale for an inversion’s predictive power is that investors would only let the government borrow at a lower cost in the long term over the short term if they believe rates are going to be lower in the future than they are now. This only to happen when central banks are trying to stave off recession. The fact that the difference in yields on 10- and two-year US Treasuries is approximately close to zero last week appears a sobering prospect for markets and the Federal Reserve alike.
However, alarm is not necessary at this point. There are other explanations for inversion that do not suggest a recession will follow as a matter of course.
Some fear that inversion indicates that markets do not buy the Fed’s claim that it can tighten monetary policy without too much of an impact on employment and will soon have to reverse course by lowering rates after its policies push the US towards a severe slowdown. Fed chair Jay Powell has consistently suggested there is considerable room for the economy to “cool” before employment is hit. But guiding something as complex as the American economy towards a “soft landing” is easier said than done. Markets understandably look upon it with scepticism.
An alternative interpretation of a potential inversion is that bond markets are on board with the Fed’s strategy and believe that inflation will stabilise in the long term. A far more concerning prospect is a steep rise in long-term yields. This would indicate market belief that high rates will be needed for some time in order to achieve price stability. At the moment, movements in equity markets indicate that many investors remain bullish — the S&P 500 has shown no signs of sustained falls.
Either way, there is good reason to think that “this time is different”. The predictive powers of inversion have never been truly tested at a time of very large central bank holdings of long-term debt. The Fed not only has to make choices about the level at which to set its main short-term policy rate but also how to manage its own vast stock of Treasuries. At present, Powell is indicating the central bank will first raise short-term rates and only then start selling its longer-dated bonds. An inverted yield curve would make some sense if markets believe the Fed will see this policy through.
Inverted yield curves may have predicted recession, but what inversion has meant in the past does not preclude a different outcome now or in the future. In any case, as all good economists know, an exception is always needed to prove a rule.