If you've been following markets lately, then you've probably heard one or two experts say they are worried about the U.S. economy dipping into a recession, a period of slowing economic activity, or even into a period of stagflation, which is marked by high inflation, high unemployment, and slow economic growth.
There are signs now that the broader market is starting to agree with some of these experts about where the economy is headed. Here are two charts that show why the recession fears are increasing.
Image source: Getty Images.
Flattening and inverted yield curves
Investors can monitor certain things to determine how the broader market views the economy and if they think it is headed for a recession. One of those clues is the U.S. Treasury yield curve. The yield curve tracks the interest rates that different U.S. Treasury bills pay out based on their length to maturity. There are two-, five-, 10-, and 30-year U.S. Treasury bills, just to name a few.
A Treasury bill in itself is just a bond issued by the U.S. Treasury Department to finance U.S. government spending, but it's important because it's also used as a benchmark for different borrowing rates paid by consumers and businesses. For instance, the yield on the 10-year Treasury bill heavily influences mortgage rates. Longer-term Treasuries typically pay higher interest rates because there is more risk involved by the very nature of having to wait longer to maturity.
Investors also view yields on Treasury bills as an indicator of how confident the market is about future economic growth, future inflation, and the future movement of the Federal Reserve's benchmark overnight lending rate, the federal funds rate. Recently, the shape of the curve has been changing pretty meaningfully.
Data source: U.S. Treasury Department. Chart by the author.
The dotted orange line shows the yield curve on March 29, 2021. As you can see, shorter-term Treasuries normally yield less than longer-term Treasuries, reflecting a steady curve up and to the right. That's considered normal and the shape of the curve one might see when the market anticipates economic expansion. The blue line represents the curve this week and shows how the yield is flattening and shorter-term Treasuries are rising. Starting at about the two-year Treasury bill, the curve flattens as several Treasuries began to yield roughly the same interest rate. We can see this even closer by zeroing in on specific parts of the curve.
2 Year Treasury Rate data by YCharts.
In the chart above, you can see that the yield on the two-year U.S. Treasury bill has significantly closed the gap with the yield on the 10-year U.S. Treasury bill. Earlier this week, it briefly overtook the yield on the 10-year, and temporarily inverted this part of the curve, which many economists and market watchers consider a precursor of a recession. In fact, Bank of America recently said in a research note that an inversion in this part of the yield curve has come before the last eight recessions.
If you think about it, the rising two-year yield makes sense. At its most recent meeting, the Fed began raising its benchmark overnight lending rate and indicated it expects six more rate hikes this year and perhaps another four in 2023, providing the market a pretty good indication of where the federal funds rate is headed over the next two years: Much higher. But the failure of the 10-year yield to adjust higher suggests the market is not currently so bullish on long-term U.S. economic growth. That's why investors typically don't see it as a good sign when the yield curve flattens.
In recent days, a different part of the curve -- the difference between the yield on the U.S. five-year Treasury bill and the U.S. 30-year Treasury bill -- also temporarily inverted. You can't exactly see it in the chart below because it was only a brief inversion, but this part of the yield curve hasn't inverted since 2006 (right before the Great Recession), according to Bloomberg.
5 Year Treasury Rate data by YCharts.
Is a recession imminent?
Not everyone believes a recession is coming. Fed Chairman Jerome Powell has argued against the notion. Some analysts also think the yield curve is being manipulated by other factors. For one, the Fed is planning to increase yields very quickly, potentially 11 total rate hikes in 2022 and 2023, which is much faster than during the last rate cycle between 2015 and 2019. The Fed has also spoken of doing a half-point rate hike all at once, which would deviate from its normal 0.25% hikes. These factors could be one reason for the fast-rising two-year yield.
Another issue is all of the money the Fed has injected into the economy since they began quantitative easing (QE), the process of buying U.S. Treasuries and other bonds like mortgage-backed securities, at the onset of the pandemic. The Fed's balance sheet had already ballooned from QE done during the Great Recession. QE in theory can push long-term bond yields down. Stan Shipley, a fixed-income strategist at Evercore ISI, suggested he thinks the 10-year yield will rise if the Fed begins shrinking its balance sheet, which it has discussed doing later this year.
The last thing to consider is that the consumer is coming from a place of relative financial strength, and unemployment is still quite low, so I don't think a recession is definite, but it's certainly much more of a possibility than it had been just months ago.
