What’s Happening With the Yield Curve Is Anything But Straightforward

Watching experts trying to follow financial markets and explain what their movements mean sometimes seems like people slipping on an icy sidewalk in winter, waving their arms about as they try to maintain their balance.

That dynamic came into play last week with reports of a Treasury bond market rally that supposedly began to reduce the negative split between shorter-term and longer-term bonds. The negative split, which creates inverted yield curves (when short-term yields exceed those of longer-term bonds), supposedly began to recede, which should be a sign that perhaps a recession might not happen.

Unfortunately, a GlobeSt.com review of data from the Treasury Department suggested the opposite. The split between 3-month and 10-year Treasurys started on January 3 at 74 basis points, with the 3-month yield higher, and ended on Friday even wider at 112 basis points. That was exactly the opposite of some reports and should have suggested a higher possibility of a recession.

And then there was the difference between the 2-year and 10-year — another portent of a recession, although considered not as definitive as the 3-month/10-year. The 2-year was higher; the gap went from 61 basis points on the third to 69 basis points on Friday. Again, the opposite of some reports.

How did anyone point to a narrowing gap/? Probably a result of intraday trading, according to John Luke Tyner, portfolio manager and fixed income analyst at Aptus Capital Advisors. “It depends on when they snap the data,” he tells GlobeSt.com. A drop can happen during a day when people are writing about the implications and then reverse direction before the end of trading.

“Humanity is so based on immediate gratification that we want to say that the Fed acted, and by them acting they fixed the problem, and we can go back to the easy money policy” of the past 15 years, Tyner added.

The longer answer is that understanding bond market dynamics is more complex. The relationship between recessions and yield inversions are really historical correlations, not necessary an issue of causation. Campbell Harvey, a Duke University finance professor who originally discovered the yield curve and recession relationship in the 1980s, has suggested the predictive power might have weakened because people recognize it and react by more prudent behavior. Although he also added that if the 3-month/10-year inversion lasted into 2023, he’d feel more confident that a recession was on the way.

“[W]hile we aren’t ignoring the signal completely we think the level of yield curve inversion is perhaps steeper/deeper than actual economic conditions may warrant,” Lawrence Gillum, fixed income strategist for LPL Financial said in an emailed note. “We think the odds are roughly a coin toss that the U.S. economy falls into a recession in 2023 but it is no sure thing. The consumer is still spending and with businesses still hiring at an elevated clip, there is a chance that we can skirt by with an economic slowdown and not an outright contraction—although if the economy does contract, we think it will be a shallow contraction due to the aforementioned reasons.”

By the way, this week the 3-month/10-year split grew to 117 basis points on Monday but then dropped to 112 on Tuesday and back up to 118 on Wednesday, while the 2-year/10-year went down to 66 on Monday and then 63 on Tuesday and 66 on Wednesday.

Whatever that will mean.