I can't believe that I am saying the "R" word, especially since the world's economy has not evenly recovered from the Covid-induced recession yet. However, with geopolitical tensions, runaway inflation and potential monetary policy mis-steps from the Federal Reserve, the U.S. economy runs the risk of going into a recession. You know by now that we will not predict whether a recession occurs or not, rather, we want to bring the facts and analyses to you. In our last post, we discussed how a recession may occur if oil prices stay permanently high. In today's post, we're going to present and analyze a historically accurate indicator/ predictor of a recession: treasury yield curve.

A Refresher On Treasury Securities and Yields

The U.S. Government issues fixed-income securities in the forms of Treasury bonds, notes or bills that can be purchased by any investors. When an individual purchases such asset, they are lending money to the U.S. government, gets paid a fixed interest rate, and when the Treasury asset matures (expires) the investor gets paid the face value of the Treasury. Buying US treasury assets generate fixed, predictable income for investors, yet are essentially risk-free because they are backed by the US government; therefore, when the yields on treasuries rise high enough to compete with stocks (which are risk assets), investors may choose to buy treasuries. 

For example, let's take a look at the 10-Year Treasury Note. As of today, you can buy the US 10-Year Treasury Note with coupon rate of 1.875%, par value of $100 unit at today's face value of $97.61 (this price is determined by supply-demand). Yearly, the US government pays you 1.875% in interest. 10 years later, the US government will pay you back $100. Calculating the coupon rate, the difference between par value and face value, yield on this 10-Year Treasury Note comes out to be about 2.15% yearly. If you are an investor and you are satisfied with 2.15% yield yearly, then stocks become less competitive. Note that if tomorrow, for some reason (i.e usually uncertainties) bond buying pressure goes up, the par value goes up, the yield goes down; the opposite is true, if bonds get sold off due to lack of demand, the yield goes up.   

Yield Curve   

The term yield curve refers to the relationship between the short- and long-term yields of the Treasuries. A yield curve plots yields against differing maturity dates. The slope of the yield curve gives an idea of future interest rate changes and economic activity. 

You may get a flat yield curve, i.e no matter how long the maturity date is, the yields are the same. Such a flat or humped yield curve implies an uncertain economic situation. It may come at the end of a high economic growth period that is leading to inflation and fears of a slowdown.

Inverted Yield Curve

But you may also get an inverted yield curve, i.e short-term yields exceed long-term yields. Such a yield curve corresponds to periods of economic recession, where the risks for short-term treasuries are so high such that investors don't want to own them (therefore the short-term yields are high). Meanwhile, investors seek longer-term treasuries because they expect the future is certainy better than the short-term, therefore, the buying pressure makes the longer-dated Treasuries more expensive, therefore driving down their yields. 

From an economic perspective, an inverted yield curve is a noteworthy event because it suggests that the near-term is riskier than the long term. Historically, inversions of the yield curve have preceded recessions in the U.S. Due to this historical correlation, the yield curve is often seen as a way to predict the turning points of the business cycle. What an inverted yield curve really means is that most investors believe that short-term interest rates are going to fall sharply at some point in the future. As a practical matter, recessions usually cause interest rates to fall. Inverted yield curves are almost always followed by recessions.   

The graph above plots the yields on the 10-year minus the 2-year since 1970. Shaded in grey are times when the US economy was in recessions. What's remarkably noticeable is that every single time the spread goes negative (inverted yield curve), the US economy went into a recession afterwards. 

Here's what the curve looks like for the past 5 years. Note the spread briefly went negative in 2019, and certainly in 2020 we hit a recession. However, this is hard to meaningfully interpret because the reason was an external, uncontrollable factor (Covid-19 virus). 

What's more concerning is that as of today, the yield curve is inverted and potentially approaching the point at which the long-minus-short term yield becomes negative (signals a recession soon). We're not there yet though. As of today, the yields on the 10-year minus 2-year is 0.26%, not negative yet, but if we get there expect fears of a recession in the market to take down stocks with a huge vengeance. 

However, keep in mind, the bond market is also a forward-looking mechanism similar to the stock market. Investors buy and sell bonds based on their perception of the economy and other geopolitical risks. Currently, economic projections and outlook still point to above-trend GDP growth.   

The Federal Reserve has recently released their economic projections (see table below). They now see the economy growing at a median of 2.8% (between 2.1 - 3.3%) in 2022, 2.2% in 2023 and 2.0% in 2024, meaning they don't expect any recession in the coming years because of strengthening indicators of economic activities and employment. An item worthy of note is that they have revised down this GDP growth expectation since they last met in December 2021, showing the Federal Reserve is also seeing/expecting a slowdown in the economy. However, this is not new to the market, as the market has been trying to price in a recession. The fact that the market priced in a recession (negative GDP growth), yet the Fed doesn't see one, means the market overshoot to the downside, or in shorter terms, buying opportunities. 

Again, to reiterate, we think the past few months the market has been trying to price in a recession, but since we won't have one, there's room to the upside for stocks.