One big recession warning signal reared its head this week.
On Tuesday, hawkish comments by Federal Reserve Chairman Jerome Powell sent the markets into a tizzy, pushing the US Treasury yield curve to its deepest inversion since 1981. This once again put a spotlight on what many investors consider a time-honored recession signal.
We’ve watched the U.S. central bank hike interest rates aggressively over the last year to combat inflation that hovered around 40-year highs. But as inflation data cooled and the Fed slowed down the pace of interest rate hikes, investors were hopeful for the economy.
But, on Tuesday, Powell told Congress the Fed would need to raise rates higher than previously anticipated in response to recent data showing that growth and inflation remain strong despite the barrage of rate increases over the past year.
“If the totality of the data were to indicate that faster tightening is warranted, we would be prepared to increase the pace of rate hikes,” Mr. Powell told lawmakers in both chambers. He was careful on Wednesday to underscore that “no decision has been made on this.”
As a result of the comments, the yield curve inverted further.
What Does That Mean?
The yield for 2-year Treasury bonds exceeded the yield for 10-year ones — by a lot.
What Should the Yield Curve Look Like?
The yield curve, which plots the return on all Treasury securities, typically sloped upward as the payout increases with the duration. Yields move inversely to prices.
A steepening curve typically signals expectations for stronger economic activity, higher inflation and higher interest rates. A flattening curve can mean investors expect near-term rate hikes and are pessimistic about economic growth further ahead.
What Does an Inverted Yield Curve Mean?
The inversions suggest that while investors expect higher short-term rates, they may be growing nervous about the Fed’s ability to control inflation without significantly hurting growth.
What Does the Yield Curve Have to do With a Recession?
The 2/10 year yield curve has inverted six to 24 months before each recession since 1955, according to a 2018 report by researchers at the San Francisco Fed. It offered a false signal just once in that time. That research focused on the part of the curve between one- and 10-year yields.
Anu Gaggar, global investment strategist for Commonwealth Financial Network, found that the 2/10 spread has inverted 28 times since 1900. In 22 of these instances, a recession followed, she said in June.
For the last six recessions, a recession on average began six to 36 months after the curve inverted, she said.
Before this year, the last time the 2/10 part of the curve inverted was in 2019. The following year, the United States entered a recession.
Related: What to Consider During a Recession
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