The point at which this key recession indicator becomes a reality is now 'only a matter of time'

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  • The spread between US 2-year and 10-year government debt just fell to a new decade-low following a speech from US Fed chair Jerome Powell.
  • Capital Economics’ John Higgins says an inverted yield curve – often a reliable indicator of recessions – is now “only a matter of time”.
  • However, Higgins said it’s unlikely to happen until the second half of next year, preceding a US economic downturn in 2020.

The yield spread between US 2-year and US 10-year government bonds just fell to a new decade-low of less than 19 basis points.

And as the spread continues to narrow, Capital Economics says an inverted yield curve is now “probably only a matter of time”.

That said, CE’s John Higgins predicts it won’t happen until the second half of next year.

He also expects bond yields to rise in the meantime — largely due to reduced safe-haven demand as trade war fears subside.

But as the 2-10 spread narrows, it will continue to get plenty of attention, given the inverted yield curve’s long history as a reliable predictor of US recessions.

This time around, the question of whether an inverted curve will give rise to the dreaded r-word is the subject of hot debate among financial experts. Earlier this month, BI’s Jim Edwards wrote a great summary of the conflicting arguments.

Regardless, there’s no doubt markets are watching the curve.

In addition, the US Fed itself said “policymakers should pay close attention to the slope of the yield curve in assessing the economic and policy outlook”.

The latest moves in US bond yields followed Fed chair Jerome Powell’s speech on Friday night. Among the highlights, Powell said inflationary forces remain muted and the economy does not look to be at risk of overheating.

The speech was interpreted as dovish by markets, and the US dollar fell while stocks rose. In addition, US 10-year bond yields edged closer towards 2.8%.

Capital Economics

At the same time, Powell said the Fed remains committed to its current rate-hiking cycle. So the Fed is almost certain to raise official cash rates next month, and CME’s Fedwatch tool is still assigning a 66% probability that rates will rise again in December.

The net effect was that 2-year bond yields held steady in anticipation of near-term rate hikes, while 10-year yields fell as markets revised their long-term inflation expectations.

That leaves the yield curve at around 18.9 basis points — the lowest level since it inverted in 2006/7 prior to the global financial crisis.

“We think that it will continue to shrink,” Higgins said.

“In the Fed’s last three major tightening cycles, the spread had fallen towards, or even below, zero at the point of the final rate hike.”

But before it inverts, Higgins said it’s likely that US 10-year bonds actually rise again in the second half of this year.

And while US 2-years will follow 10-years higher, Higgins said the moves may take near-term pressure off the yield spread.

“We forecast that the 10-year Treasury yield will climb back up to 3.25% later this year, as some of the factors that have kept it down in the face of tighter monetary policy unwind,” Higgins said.

“This includes recent safe-haven flows tied to concerns about the trade war and its effects on emerging economies.

“While this could prevent the spread between 2-year and 10- year Treasury yields from shrinking further this year, we do expect it to fall to, or below, zero in the second half of 2019.”

Higgins then expects the 2-10 yield curve to return to positive territory in 2020, in response to a US economic slowdown after the current Fed tightening cycle has reached its peak.

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