In 1986, Campbell R. Harvey proved incontrovertibly that inverted yield curves forecast U.S. recessions. While this prediction does not hold in other countries, its 100% hit rate in the U.S. before 1986 was stunning evidence of a predictable trend—especially stunning because there are no other reliable recession predictors. Not that people haven’t been looking for them, either; predictors of macroeconomic trends are always being hunted because of their profitability, and the recession predictor is something of a holy grail. To say Harvey’s accomplishment was substantial is a massive understatement.
What makes it an even more amazing accomplishment is that, since then, the predictor has worked three times again for every three times the 2-year Treasury yield was higher than the 10-year Treasury yield. Other Treasury yields also inverted, but the 2/10 year spread is the biggest focus because, historically, it was the first inversion to occur.
Of course, things are different now.
Things always change in finance, which always brings uncertainty to financial decisions. This time, the uncertainty derives from the fact that the 2-10 year spread has not gone negative, but we do see a negative spread with other durations. Time for some charts.
Note how the 10-year rate is now 21 basis points below the 3-month and 6-month rates, while the 1-year rate is 7 basis points above the 10-year. We are now seeing these inversions:
3mo/1yr
3mo/10yr
6mo/1yr
6mo/10yr
1yr/10yr
This looks bad, but it gets worse.
This chart shows us that the 3mo and 6mo Treasury rates are also inverted with the 2year and 3year yields. The yield curve only looks non-inverted if you ignore the shortest end of the curve—then things look normal:
What is this telling us? The bond market things something is very strange in the short term—something that is expected to get rectified within a year. To answer what exactly that could be, we should look at the futures market—namely, futures on U.S. Treasuries.
This chart comes from the CBOE, and it compiles the Federal funds target rate as implied by the futures markets. The current target rate is 2.25%-2.50% , and the market is currently saying there is a 1.7% probability that the rate target will be that in the next year.
In other words, there is a 98.3% probability that the Federal Reserve will cut interest rates.
This doesn’t mean a recession will not happen. It merely means the bond market believes the Fed will cut its rate target in the next year, which might be the response of worsening economic conditions. Or the bond market could be wrong and the Fed doesn’t, which will prompt a recession that thus forces the Fed to lower rates. There are many interpretations, from an economic perspective, to the single view that the bond market clearly does have: the Fed will cut interest rates in the next year.
Is the market right or wrong? That’s up for you to decide.