U.S. Yield Curve Inversion and the Recession Question
Bottom line: The10-2yr U.S. Treasury yield curve has become more inverted during July and is consistent with data elsewhere signaling that a recession is around the corner. It will be interesting to watch how far the yield curve inverts in the context of the debate about the size of the U.S. recession. On our view of a mild U.S. recession, we would suspect that around 50bps is the maximum inversion, and as Fed tightening slows to a stop, a positive yield curve could be seen again into 2023.
Figure 1: 10-2yr U.S. Treasury Yield Curve (%)
Source: Datastream, Continuum Economics
Yield Curve Inversion and the Recession Story
The 10-2yr U.S. yield curve has become more clearly inverted since the start of July, as the money market has shifted from forecasting a peak of 3.25% to 3.75% Fed Funds after the recent U.S. employment report and CPI figure (here). 10yr yields have not returned to the highs seen in mid-June, both as end investors snapped up long-dated bonds at high yields and as recession views have grown.
Long-dated bonds are now seen to be a partial portfolio hedge against further declines in the U.S. equity market. We remain of the view that the S&P500 will likely fall to 3,500, as 2023 earnings expectations are cut. Part of this process could start in the next couple of weeks, with bottom-up analysts having cut Q2 forecast earnings across a range of companies over the past fortnight, but it will be the Q3 and Q4 guidance from earnings season that will be key. It could well be that the Q3 earnings season in October causes a proper rethink and that the earnings uncertainty persists until then. Meanwhile, the forecasts about recession in the U.S. have picked up steam over the past month, which is the other big factor capping 10yr yields and causing the yield curve inversion.
U.S. consumption is clearly slowing, while some of the short leading indicators are also suggesting that the U.S. economy is slowing noticeably. We maintain the view that a proper, though mild, recession is likely by late 2022 or early 2023, as outlined in the June Outlook (here). A technical recession is also feasible in Q1 and Q2 due to excess inventory destocking, but domestic demand would still be reasonable enough to allow expectations of a positive Q3 GDP. While the Fed appears set to deliver 75bps at the July 27 FOMC meeting, real sector and inflation data will be key in shaping FOMC views ahead of the Sept. 21 meeting and how the Fed guides expectations into 2023.
Figure 2: U.S. House Prices and CPI Owner Equivalent Rent (y/y %)
Source: Datastream, Continuum Economics
For Fed policy it is not just a question of real sector data, but also the inflation figures. After the CPI, the focus is on the UoM inflation expectations July 15, which were revised down to 3.1% last month from a provisional 3.3% — remember that Fed Chair Jerome Powell cited this as one of the reasons for a 75bp hike in June. We will also look closely at the June PCE inflation figure on July 29. Powell has guided that headline inflation is important as this impacts inflation expectations and price setting behavior, despite the Fed also looking at core inflation. However, the July meeting could see the Fed reminding the market that the most important measure is PCE inflation. Headline CPI in July will be helped by the reversal of gasoline prices, but monthly core CPI remains more elevated than core PCE inflation, which has been 0.3% for the past four months. One of the reasons is the high weight in CPI for owner equivalent rent. The slowdown in the U.S. housing sector (Figure 4) should slow the trajectory of this component of CPI, but it could take into 2023 to feed properly into lower owner equivalent rent. Fed communications need to talk more about PCE inflation to allow the Fed flexibility to slow the pace of tightening after July. However, this will likely be subtle rather than forthright.
One point worth clarifying is the decline in the monetary base being seen recently and noted by some economists. This is a function of the Fed quantitative tightening (QT) program. M1 is a better indicator for money and this has been slowing on a 3mth annualized basis (Figure 3). However, M1 and M2 have not been great leading indicators in themselves and need to be seen in conjunction with a wide assessment of economic data. We would, however, be interested in the Fed loan officer survey data that is due later in July.
Figure 3: U.S. M1 Growth 3mth Annualized (%)
Source: Datastream, Continuum Economics (Note April-July 2020 huge jump is not shown to allow historical movements to be seen).
Returning to the 10-2yr yield curve, we do regard the inversion as being consistent with a U.S. recession call, alongside other data. Even so, it will be interesting to see how far the yield curve inverts, as a signal of the scale of any U.S. recession. With the Fed undertaking QT, the long end of the curve may not invert too significantly, and we would see 50bps as being the maximum, unless other data suggested a deep recession — not our central view.