What are bond yields telling us today?

AAs investors digested both the Fed’s decision to raise interest rates an additional 75 basis points and news that US economic growth slowed in the second quarter, a significant yield curve inversion – perhaps the strongest harbinger of an impending recession – has gone largely unnoticed.

The yield on the two-year US Treasury now stands at 2.85% as of August 2, putting it 31 basis points above the yield on the 10-year US Treasury. Usually, of course, the longer term security would have a higher yield than its shorter term cousin. When the yield curve inverts, this relationship is upset. One of the reasons for these reversals is that short-term yields are more heavily impacted by Fed rate hikes than longer-term yields.

More importantly, this inversion is now at its most extreme point in decades: the spread between 2-year and 10-year yields is at a level not seen since the bursting of the tech bubble in the early 1990s. 2000 (see graph).

The gap between these two returns is generally considered a reliable predictor of economic conditions. Consider:

  • The yield curve slid to negative – inverted – levels an average of 15 months before the onset of recessions since 1973.
  • Of the four recessions we have experienced since 1980, all were preceded by a reversal of the 2-year/10-year spread.
  • Additionally, the Federal Reserve has raised interest rates before every recession since 1954.

That said, the 2-year/10-year spread is only a single indicator, which does not have a perfect track record for predicting recession. There have been periods—1998, for example—when there was no recession following an inversion. There is also the problem of timing, as some recessions started soon after a reversal while others took up to 24 months.

The bottom line: making rash moves following an inverted yield curve is not a guaranteed recipe for successful goal-based investment results. Additionally, investors may want to consider the upside potential of stocks and other assets if a recession does not occur.

This commentary is written by the Horizon Investments asset management team.

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