Treasury Yields Fact vs Fiction: Is a Recession Really on the Way?

These past few weeks have been especially notable to economists as the 2- and 10-year Treasury yield curve inverted on three separate occasions. When a yield curve inverts — that is, when a long-term Treasury gives a smaller return than a shorter-length bond — many analysts immediately assume a recession is on the way. Deutsche Bank has already laid out baseline expectations for a recession beginning in late 2023. However, not everyone feels as confident in the government bond’s signal. Are Treasury yields really the recession indicator some economists make them out to be?

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First, let’s acknowledge the elephant in the room: Yes, inverted 10-2 year Treasuries have predicted every US economic recession since the 1950s. The 10-2 yield spread has historically been a near-foolproof economic indicator, which alone justifies many economists’ recent stance.

That said, today’s macroeconomic circumstances are far different in many ways. To that end, officials at the Federal Reserve, including Chairman Jerome Powell, have already somewhat discounted the 1o-2 Treasury yield indicator. Powell and others have stated preference for the spread between the 3-month and 18-month Treasuries as a superior economic indicator. Unlike the 10-2 year curve, the gap between the 3-18 month Treasuries has only widened since the start of the year.

This perspective isn’t just a bullish denial of reality. Rather, there are legitimate points of complaint against the most popular long-term bonds as being less reliable indicators than what has historically been true.

The 10-year Treasury has had a negative real yield — nominal yield minus expected annual inflation — for “nearly the entire pandemic.” This is largely because of the Fed’s rampant bond-buying program enacted to artificially lower interest rates when Covid-19 first took hold of the economy.

Long-Term Treasury Yields Lost Predictive Power in Pandemic

Since March 2020, the Fed has purchased more than $4 trillion in government-backed securities. As a result, the 10-year Treasury has seen its price rise while its yield has been forcibly pushed down toward the 2-year Treasury’s return.

Some economists argue this has perhaps substantially reduced the yield spread’s power as a recession indicator. After all, the US economy has never really seen a bond-buying program of this magnitude before. The Fed currently holds more Treasury notes and bonds than in its entire history. As such, the yield investments — which have each been quite short — could be reasonably attributed to the actions of the central bank rather than the invisible hand of the economy.

In addition, because the investment-recession relationship is so well established, some economists argue the Treasury’s predictive power may have been lost along the way. After all, rampant uncertainty is one of the greatest drivers of a recession. If everyone is able to act with all relevant information available to them, there’s less cause for a widespread, uncertainty-fueled selloff. Because businesses can act defensively in anticipation of a downturn, it could be possible to avoid a recession all together.

Despite the 10-2 yield spread’s track record, viewing it as the end all, be all would simply be a mistake. Taking relevant drivers of a yield investment into account, investors should look at the recent yield curve dips with a grain (or two) of salt. Time will surely tell whether Treasury yields are truly the recession-predicting mechanisms some analysts make them out to be.

On the date of publication, Shrey Dua did not hold (either directly or indirectly) any positions in the securities mentioned in this article. The opinions expressed in this article are those of the writer, subject to the InvestorPlace.com Publishing Guidelines.

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