When the Federal Reserve pushes shorter-term interest rates above long-term Treasury yields, it has typically been a sign that the central bank has tightened to the point that a downturn beckons. Confidence in the predictive power of such yield curve inversions is a big part of why many investors believe the economy is now destined for a recession.
But what if the yield curve isn’t inverted because the Fed has raised rates too high, but because long-term Treasury yields are too low?
Different people focus on different parts of the yield curve when making recession calls. Some look at the difference between the yields on the 2-year and 10-year Treasury notes, which inverted last July. But there have been 2-year/10-year inversions where no recession ensued. The better gauge historically has been the difference between 3-month Treasury bill and 10-year note yields, which was comforting until that, too, inverted last fall. The yield on the 3-month bill is now about 5.2%, versus the 10-year’s 3.5%.
Even on that measure, the correlation between yield curve inversion and recession at times seems spurious. The curve inverted in 2019, for example, but imagining it forecast the sharp recession triggered by the Covid-crisis hit seems a bit much. Believing that the 1989 inversion forecast the 1990 recession—which started after Iraq’s invasion of Kuwait sent oil prices sharply higher—is also a stretch.
Still, we don’t get to run the experiments where Covid-19 didn’t happen and Saddam Hussein decided against invasion to see if recessions would nevertheless have occurred. And the basic insight holds: An inverted yield curve indicates a belief among investors that in the future the Fed will be cutting interest rates, and nothing makes the Fed cut rates like a recession.
Right now, investors think rate cuts will be coming in short order. Interest-rate futures imply the central bank will have cut its rate range, which currently stands at 5% to 5.25%, by at least a half percentage point by the end of this year. By this time next year, they suggest the range will have been cut to around 3.75% to 4.0%.
Yet that would still leave rates higher than investors, on balance, seem to think they ought to be. The median expectation among market participants surveyed by the Federal Reserve Bank of New York in March put the average level of overnight interest rates over the next 10 years at 2.88%. The Fed’s latest projections, also from March, show policy makers’ median longer-run expectation for overnight rates—their just-right assessment of where rates would be to keep the job market strong and inflation in check—is 2.5%.
It is possible that both investors’ and policy makers’ assessment of where rates will eventually land is too low—conditioned by the low-rate regime that existed before the pandemic. If the economy evades recession over the next year, for example, with inflation cooling and unemployment staying low, the Fed might not be moved to trim rates by very much.
Similar things have happened before: When rates started falling after the Fed’s successful fight against high inflation in the early 1980s, investors couldn’t quite believe it, and forward rate expectations were higher than where actual rates ended up landing. When the Fed started collecting policy makers’ rate projections in 2012, the median longer-run rate projection was above 4%, yet the highest the midpoint of policy makers’ target range on rates got over the next 10 years was 2.375%.
The pandemic changed a lot of things, and one of the things it might have done is pushed the just-right level of rates higher. If the inverted yield curve turns out not to be a recession signal, it could be signaling that investors have made a mistake.
Write to Justin Lahart at [email protected]