The US Treasury yield curve may be normalising – but it is still inverted

WALL Street stocks have come under severe pressure in recent weeks, thanks to spiking bond yields, with the 10-year Treasury on Tuesday (Oct 3) yielding 4.8 per cent, the highest in 16 years.

Although equity investors are fretting, from one point of view this is a welcome signal – the 10-year yield was 4.1 per cent just a month ago, versus the six-month yield at 5.6 per cent.

The large gap of 150 basis points between the two, plus the fact that the yield curve was inverted with short-term bonds yielding more than those with longer tenures, led many to maintain their forecast that the US economy is headed for a recession.

The narrowing of the gap between the two in recent weeks to 80 basis points – the six-month yield is still around 5.6 per cent – suggests that the yield curve is slowly normalising, although still inverted. In other words, surging longer-term yields, while bad for stocks, could signal growing optimism that the US economy is headed for a soft landing.

Under normal circumstances, investors typically demand higher yields when they invest their money for longer periods as more time means more risk. Hence a normal yield curve – one where yields rise along the curve as bond maturities lengthen.

History suggests that when the opposite occurs, ie when short-term bonds yield more than longer-term bonds as is the case now, it is a warning signal for the economy, even potentially a precursor to a recession.

Inversion usually results when the Fed tightens the availability of credit. As companies find it more expensive to maintain inventories, they cut back on production and may lay off workers, and manufacturers reduce their orders for raw materials. If the Fed over-tightens, a recession results.

Another line of reasoning is that inversion shows that investors are moving money away from short-term bonds and into longer-term ones. This suggests that the market as a whole is becoming more pessimistic about the economic prospects for the near future.

An inverted curve has accurately foreshadowed all 10 recessions since 1955, according to data from the Federal Reserve Bank of San Francisco, with only one false positive in the mid-1960s.

However, those who believe the bond market is currently embracing the soft landing scenario point to a resilient US economy – unemployment is 3.8 per cent, gross domestic product grew at an annualised rate of 2.1 per cent in the second quarter of 2023, versus Q1’s 2 per cent, and inflation has been brought down from about 8 per cent in 2022 to 3.67 per cent, after 11 interest rate hikes in the past 18 months.

One reason for the economy’s strength is the significant amount of fiscal stimulus in the form of government payments to individuals and businesses that helped boost the economy during the Covid pandemic.

Steady consumer spending, buoyed by the strength of the labour market, has helped keep the economy on a growth trajectory. For corporates, government aid has meant that most companies have been operating with reasonably strong balance sheets and have not had to issue new debt at the current elevated levels.

However, the average lag time between when the curve inverts to start of recession can span 12 to 24 months, according to the San Francisco Fed, which means although the yield curve may be normalising, the economy may not yet be out of the woods.