Why traders think the US economy is about to go into reverse

A warning sign for the world’s biggest economy is flashing on the dashboard of bond markets.

Part of the Treasury yield curve has inverted, a strong signal that nervy investors are bracing for a US recession. Yields on short-term government debt are surging in a global bond rout as expectations rise of central banks responding to decades-high inflation with interest rate increases.

What has happened?

Long-dated debt, such as 10-year and 30-year government bonds, usually have higher yields than short-term debt such as two and five-year bonds, as investors are compensated for keeping their money locked up for longer.

However, this is flipped in an inversion of the yield curve, meaning yields on short-term bonds are higher than long-term bonds. This is rare and has become one of investors’ most trusted recession signals.

This time, yields on five-year Treasuries, or US government debt, rose to 2.64pc – compared with 2.58pc for 30-year Treasuries. It was the first time this has happened since 2006.

The most closely watched part of the yield curve is the difference between two-year and 10-year Treasuries. This is also on the brink of inverting.

Why has part of the yield curve inverted?

The inversion signals that investors expect central banks will need to cut interest rates in response to a recession, perhaps after tightening monetary policy too quickly.

Yields on short-dated bonds have surged on mounting expectations of central banks responding to rampant inflation with higher interest rates.

The US Federal Reserve is expected to raise interest rates as many as eight times this year with its chairman, Jerome Powell fueling hike bets with hawkish signals in recent weeks. The Bank of England is also expected to raise interest rates several times in the next 12 months.

What does it mean?

The US Treasury yield curve has been a reliable predictor of recessions in the world’s largest economy.

The flipping of two-year and 10-year Treasury yields has been followed by a US recession every time it has happened in the last 50 years. The recession typically follows within 18 months.

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And when America sneezes, the world catches a cold. Some economists are already warning of rising recession risks in the UK as consumer confidence is battered by the cost of living crisis being worsened by the war in Ukraine.

It could also spell trouble for stock markets with rapidly rising yields a potential headwind for shares.

Althea Spinozzi, an analyst at Saxo Bank, explains: “This, at some point, is a dangerous moment for markets, as a steep back-up in treasury yields preceded every major bear market or market correction in recent decades, most infamously ahead of the 1987 crash, but also into early 2000, 2007 and 2018.”