How We Got Here
In mid-March, the Fed embarked on a much-anticipated series of rate hikes. It did so in the face of major global economic uncertainty surrounding rampant inflation, a highly unpredictable war in Ukraine, and the potential for a slowdown in growth.
Fed interest-rate hikes, which always focus on short-term rates, tend to put upward pressure on the front end of the curve (i.e., the short end). But uncertainty and slow growth often weigh down long-term rates (i.e., the long end). In the current environment, in which the Fed has already hiked the benchmark federal funds rate by a quarter of a percentage point with additional hikes expected, the most recent inversion was not completely surprising. If anything, the stronger-than-expected April 1 jobs report from the US Labor Department seemed to provide more ammunition for the Fed to keep hiking rates.
Does this mean you should run for the bunker? We don’t think so. In our view, the issue at hand is one of timing. Despite the recent yield-curve inversions, the time period between inversion and recession often varies, can take months to develop, and can occasionally be triggered by events completely unrelated to market forces. To put it another way: not all recessions are equal.
Let’s take the last recession as an example. It was widely recognized that the US was in recession in early 2020 as a result of the COVID-19 pandemic. However, that same recession is also now recognized as the shortest on record—lasting only two months.3
The catalyst behind that recession was COVID-19. The resulting health precautions sent many countries into lockdowns, caused unemployment to soar, and sent equity indexes crashing. But did an inverted yield curve predict COVID-19? Was the curve inverted at the start of January 2020, shortly after the first cases of COVID-19 were discovered? It wasn’t. The spread between short and long-term rates at the time showed an upward-sloping curve.
Conventional wisdom looks at the points on the curve for the 2-year Treasury vs. the 10-year Treasury to determine if it has inverted. On the last day of 2019, the 2-year Treasury yield stood at 1.57% and the 10-year Treasury yield stood at 1.91%. A 34-basis-point spread is considered tight by historical standards—but not upside down. However, the curve did briefly invert by three basis points a few months earlier during August 2019—2-year Treasuries at 1.50% vs. 10-year Treasuries at 1.47% on August 28, 2019. Interestingly, from that date forward until the end of the year, the S&P 500 Index4 returned 13.37% (see FIGURE 3).