Market Pulse: September 9, 2024

In late March 2022 the yield on the 2 Year Note rose above the yield on the 10 Year Note. The 2/10 curve was inverted for the first time since 2019, but it didn’t last long, just a couple days. It wasn’t until three months later, in early July, when the yield on the 2 Year went higher than the 10 Year and stayed there. For brief moments in the spring and summer of 2023, the 2 Year yield was more than one hundred basis points north of the yield on the 10 Year; that was the biggest inversion for in this part of the Treasury curve since the early 1980s.

However, in the last couple of trading days the 2 Year was yielding less than the 10 Year for the first time in over two years; not by much, a handful of basis points, and there is no telling if this is the end of the story. But, as you can see from the monthly chart of this spread, if past is prologue, the 2 Year yield will fall below the 10 Year by at least 100 basis point over the medium term.

As you can also see on the chart the inversion of the 2/10 spread has for at least the past four decades signaled that a recession is on the way. Although this spread looks to be predictive, it is not considered by some experts to be the best signal of trouble up ahead amongst the various Treasury spreads. While it can certainly be said that each of the Treasury spreads are usually highly correlated, you have to look to the 3-Month/10 Year yield spread to find the best of breed.

There is a notable difference in the at the present time between the 2/10s and the 3m/10s. While the 2 Year yield has fallen back under the 10 Year yield, the 3-month Treasury Bill remains premium to the 10s by about 140 basis points. Additionally, this curve did not invert until about four months after the 2/10 did, in late October 2022, the inversion got much steeper, at 189 basis points, and there was no false flag, such as 2/10 short lived inversion of March 2022. These are among the reasons the 3m/10Year is considered the spread to follow. At least that’s the opinion presented in one of the definitive articles on the matter:

“The Yield Curve as a Leading Indicator: Some Practical Issues”, written by economists Arturo Estrella and Mary Trubin, published in the summer of 2006 in the New York Fed’s Current Issues in Economics and Finance. The article explains that the relationship between the yield curve and recessions can come from many factors, but two in particular must be noted.

“Monetary policy can influence the slope of the yield curve. A tightening of monetary policy usually means a rise in short-term interest rates, typically intended to lead to a reduction in inflationary pressures. When those pressures subside, it is expected that a policy easing—lower rates—will follow. Whereas short-term interest rates are relatively high as a result of the tightening, long-term rates tend to reflect longer term expectations and rise by less than short-term rates. The monetary tightening both slows down the economy and flattens (or even inverts) the yield curve.

Changes in investor expectations can also change the slope of the yield curve. Consider that expectations of future short-term interest rates are related to future real demand for credit and to future inflation. A rise in short-term interest rates induced by monetary policy could be expected to lead to a future slowdown in real economic activity and demand for credit, putting downward pressure on future real interest rates. At the same time, slowing activity may result in lower expected inflation, increasing the likelihood of a future easing in monetary policy. The expected declines in short-term rates would tend to reduce current long-term rates and flatten the yield curve. Clearly, this scenario is consistent with the observed correlation between the yield curve and recessions.”

While the 10 Year Note is the clear and logical choice for the long end of the spread, the short end of the curve is not so obvious. There are some that favor the 2 Year Note and others that prefer the Fed Funds rate. But the authors see the 3-month as the best alternative. “With regard to the short-term rate, earlier research suggests that the three-month Treasury rate, when used in conjunction with the ten-year Treasury rate, provides a reasonable combination of accuracy and robustness in predicting U.S. recessions over long periods. Maximum accuracy and predictive power are obtained with the secondary market three-month rate expressed on a bond-equivalent basis, rather than the constant maturity rate, which is interpolated from the daily yield curve for Treasury securities.”

The Two Year, they say inverts too early and too often, suggesting the possibility of a false signal. The 3-month, however has been unerring for almost six decades. Since 1968 the “…The monthly average spread between the ten-year constant maturity rate and the three-month secondary market rate on a bond equivalent basis has turned negative before each recession…” No false signals from this spread; “…very low positive spreads have not been followed by recessions.” (This chart is from the New York Fed, but not from the Estrella/Trubin article.)

You will note that the current inversion is amongst the steepest in this data series. That fact alone might offer information in regards to the predicted recession. The authors commented on variation in the level at which the spread bottomed out over the years, “We note, however, that while we focus here on predicting the occurrence and not the severity of recessions, there is evidence that more pronounced inversions—as in the early 1980s—have generally been associated with deeper subsequent recessions.” So, there is that to consider.

On other feature of this analysis comes from Estrella/Trubin converting the 3-Month/10 Year spread into a probability of recession twelve months ahead. Here another NY Fed chart that graphs this probability.