Robust Recession Indicator Tells Two Different Stories For U.S. Markets

An inverted yield curve is something to watch closely as a historically reliable barometer of U.S. recessions. Generally, the slope, or term premium, of U.S. Treasury bonds has been robust predictor of a coming U.S. recession when it turns negative over recent history. The New York Fed summarizes the data and latest forecasts here.

A Tale Of Two Yield Curves

10 Year Less 2 Year Spread

Currently the U.S. yield curve is flattening, but there are some important differences depending on what metric you look at. If you look at the difference between 10 year and 2 year yields, as you can see here, at the time of writing the prospects for yield curve inversion look ominous. The term spread is broadly declining to levels we last saw exiting the last recession. It’s not inverted yet, but it could be coming.

10 Year Less 3 Month Spread

However, the difference between 10 year and 3 month bond yields tells quite a different story. You can see that picture here, and things seem a lot more positive. The spread here is quite healthy and suggests we may see further growth, rather than a recession.

Divergence

This divergence is somewhat unusual. Typically it doesn’t make too much difference which metric you look at, both spreads have been negative leading into a recession. However, most academic papers do lean towards using the difference between 10 year and 3 month yields as the preferred forecasting metric for recession. That’s good news as this is the more optimistic of the two metrics, for now.

Fed Tightening

However, that vaguely positive picture could well change. The CME’s FedWatch Tool does show that markets believe the Fed may raise rates anywhere between three and ten times in 2022. With a chance of a big move at next month’s meeting. Should that happen, then the two metrics for measuring the slope of the yield curve may become a lot more consistent.

Both may increasingly flash a warning for a U.S. recession should the Fed chose to tighten rates over the coming months. However, we still have some way to go before the yield curve does imply a recession is on the way. For now it’s something to monitor rather than a clear warning sign.