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Bonds are on the brink of sounding the recession alarm

A statue of Albert Gallatin stands outside the U.S. Department of the Treasury building stands in Washington, D.C. Photographer: Andrew Harrer

U.S. 10-year Treasury yields (^TNX) rose to their highest level in nearly seven years this week. But it’s the yield curve that investors say they’re watching, as it could be portending a recession on the horizon.

The difference between the yield on U.S. Treasury 2-year notes and 10-year notes has been closely watched as it has plumbed to its lowest level since the 2008 financial crisis. Historically, a yield curve inversion — meaning 2-year notes pay bondholders more than 10-year notes — has been the canary in the coal mine that forecasts an economic downturn.

The combination of higher bond yields, particularly in shorter-dated maturities, and the looming threat of recession has some fund managers de-risking their portfolios.

Evidence that we are in the later stages of this economic expansion

Bill Merz, director of Fixed income at U.S. Bank Wealth Management, said he’s increasing his holdings of short dated U.S. Treasuries and cutting back on riskier high yield bonds. He said he and the U.S. Bank team are looking at reducing exposure to equities in favor of bonds if it becomes apparent the business cycle has peaked.

“Now that the short end of curve is offering yields that are non-zero that’s a big shift,” Merz said. “We’ve been in this environment where for years to earn anything meaningfully above zero you really had to step out on the curve and in terms of risk.”

A chart of the 10-year U.S. Treasury note’s yield vs the 2-year note’s yield since 2013 from the St. Louis Federal Reserve’s FRED tool.

The yield curve is flattening across the board. The difference in yield – or the spread – between 5-year Treasury notes ( ^FVX ) and 30-year bonds (^TYX) has sunk to 26 basis points, its lowest since 2007. And the difference between what investors are paid to hold U.S. government debt maturing in 10 years and debt maturing in 30 years has fallen to around 12 basis points, or 0.12%.

“It’s evidence that we are in the later stages of this economic expansion,” Guy LeBas, chief fixed income strategist at asset manager Janney Montgomery Scott, told Yahoo Finance. “I suspect we’ll see an inversion the end of this year or early 2019, which is a harbinger of recession probably in 2020.”

The yield curve inverted before the recessions of 1981, 1991, 2000 and 2008. In fact,  it has predicted all nine U.S. recessions since 1955, with a lag time ranging from six months to two years.

The Fed is watching

“One of the most pervasive relationships in macroeconomics is that between the term spread—the difference between long-term and short-term interest rates—and future economic activity,” the San Francisco Fed’s Michael D. Bauer and Thomas M. Mertens wrote in March.

Atlanta Fed President Raphael Bostic even said it was his job to prevent the curve from inverting, joining a number of other U.S. central bank bosses who have openly voiced concern about inversion in recent weeks.

But it seems the Fed is doing little to stop it. Chair Jerome Powell said the Fed expects to raise rates twice more this year and another three times next year, and Fed funds futures prices show the market largely believes them. The market shows a 95% likelihood of a hike in June, 74% chance in September and is evenly split on a December rate increase, which would be more than the Fed’s forecast, according to CME Group’s FedWatch tool.

A year-to-date chart showing the rise in 2-year U.S. Treasury notes, the most sensitive to increases by the Fed to the overnight interest rate.

Short-dated yields are expected to rise as the Fed increases U.S. overnight interest rates, but long-term yields are more related to expectations of inflation, which the market has largely written off, analysts say. That’s the result of expectations for recession and a belief that inflation has been held down by the post-financial crisis economy in which companies like Amazon keep producers from raising prices and automation and a lack of collective bargaining keep employees from scoring higher paychecks.

If the trend continues, 2-year notes will yield more than their 10-year counterparts soon. Though, that may be a moot point.

Yield curve inversion is a reflection, not a cause

“The curve doesn’t have to invert for the economy to go into recession,” said Subadra Rajappa, head of U.S. rates strategy at Societe Generale.

Rajappa and others noted that while many associate a yield curve inversion with recession, it’s ultimately a reflection of the kind of economic conditions that portend a bust rather than a cause. An inverted yield curve is a sign investors think the government is less likely to pay back debt it owes in two years than what it owes in a decade. Market analysts have pointed to everything from the increase in U.S. debt to cyclical factors like the market running out of steam as reasons for a downturn.

On the other hand, Morgan Stanley’s head of wealth management, Lisa Shalett, notes that an inverted curve is “not yet imminent,” and that even if it does happen that won’t mean the economy immediately begins to falter.

“Concern about inversion is well-founded, as a completely flat curve suggests limited incentives for either investment or lending,” Shalett wrote in a note to clients. “In our analysis, however, this inversion doesn’t affect the real economy immediately. In fact, it typically precedes a decline in economic output as measured by industrial production by nine to 18 months.”

So there may be some time.

UBS analysts pointed out in a note on Tuesday that the benchmark S&P 500 stock index has rallied ahead of each instance of curve inversion by an average of 15% over 12 months. After the curve inverted, the S&P rallied an average of 29% to the equity peak, they said.

Still, that doesn’t change the path the market is taking, said Aaron Kohli, rates strategist at BMO Capital Markets. Treasuries pricing is showing that “the risks to a recession have gone up,” he said, and it’s not typically wrong. The real question is a matter of time.

“The debate between economists is not, ‘Is there no risk to recession?'” Kohli said. “It’s ‘Is the risk [of recession] this year, next year or the year after?'”

Dion Rabouin is a markets reporter for Yahoo Finance. Follow him on Twitter: @DionRabouin.

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