- US 10-year bond yields are now lower than three-month Treasury yields for the first time since 2007.
- Since the 1970s, whenever this part of the US yield curve has inverted, a US recession has soon followed.
- Not everyone agrees that the inversion means a recession will occur on this occasion.
US 10-year bond yields are now lower than three-month Treasury yields for the first time since 2007.
Since the 1970s, whenever this part of the US yield curve has inverted, where longer-dated yields are below shorter-dated equivalents, a US recession has followed soon after.
It’s little wonder why recession talk has been rife in markets in recent days, and led to an abrupt selloff in cyclical assets on Friday when the curve actually inverted.
While unsettling news, the Commonwealth Bank’s rates strategy team isn’t overly concerned.
They believe this time could be be different.
“A lot has changed since the financial crisis,” strategists at the bank said in a note.
“One of the things that has changed is that the combination of QE, issuance and regulations has lowered the 10-year term premium materially. That makes it much easier for a shorter-term rate to be over the US 10-year yield.”
Term premium is the excess return investors demand for holding a longer-term bond as opposed to a shorter-dated equivalent.
Previously, the excess return demanded by investors for holding a longer-dated bond was significantly higher. However, as seen in the chart below from the CBA, the premium for longer-dated bonds has fallen sharply in the post-GFC era, in part because of asset purchases undertaken by major central banks as part of quantitative easing (QE) programs.
With term premiums for longer-dated bonds now significantly lower than in the past, strategists at the Commonwealth Bank suggest the current inversion of the curve is not all that unusual, especially given the increase in short-term interest rates in recent years due to previous rate hikes from the Fed.
“If the 10-year yield is much lower than you might otherwise expect it to be for structural reasons like QE then it is much easier for other rates to rise higher than the 10Y and cause inversions,” it said.
“When looking only at the unaltered three-month and 10-year rates the inversion of the [curve] is a very clear indicator that there is a recession looming.
“However, when looking at the spread between the three-month yield and the underlying 10-year expectations — that is, 10-year yields net of term premium — the current slope of the US curve remains surprisingly steep.”
Given that it’s now easier for the US bond curve to invert, the Commonwealth Bank believes the information about the outlook for the US economy from the shape of the curve may not be as useful as periods in the past.
“Does that mean that the inversion of the US curve no longer holds the information value it once did? We suspect so, but only time will tell,” it said.
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