Wall Street might be looking at the yield curve all wrong.
The difference between the yields on two- and 10-year Treasurys — plotted on the yield curve — has shrunk to its lowest level since 2007 and has set off the alarm on whether a recession will follow. After all, the gap has fallen below zero, in what is known as a yield-curve inversion, before every US economic downturn since the 1960s.
The logic is that as investors become wary of the economy’s growth prospects, they demand a higher yield for holding shorter-dated bonds.
But according to new research from the Federal Reserve Bank of San Francisco cited by Bank of America Merrill Lynch, the 2y10y yield curve in particular and the difference between short- and long-term bonds in general hold less predictive power than is widely believed.
“When interpreting the yield curve evidence, it is important to remember that the predictive relationship in the data leaves open important questions about cause and effect,” the San Francisco Fed paper, authored by Michael Bauer and Thomas Mertens, said.
The paper, released Monday, further argued that the relationship between three-month and 10-year Treasurys was a more useful harbinger of recessions than the often-cited gap between two- and 10-year yields. And the three-month 10-year curve is further from inverting.
Even with the 2y10y curve at 19 basis points, its lowest since 2007, Aditya Bhave, a global economist at BAML, seems unfazed.
For one, he’s not in the camp that believes an inverted yield curve causes a recession. Rather, he said, it’s the other way around: Fears of a recession cause the curve to invert.
“The point is that the yield curve is better viewed in the context of the macroeconomic and policy environment than as a leading economic indicator,” Bhave said in a client note on Wednesday.
Short-term rates are rising (and pushing the yield curve closer to inversion) partly because the Federal Reserve has been raising interest rates. The Fed is expected to hike again at its policy meeting in September — that would be its eighth rate increase in three years — and to continue raising borrowing costs at least through the middle of next year.
Given this trajectory, there have been questions on whether the Fed would tolerate an inverted yield curve and for how long. Officials, including Robert Kaplan, the president of the Fed’s Dallas branch, have said they’d rather the curve did not invert.
But others, like Loretta Mester, the president of the Cleveland Fed, think it’s not as reliable a recession indicator as it used to be.
Bhave said an inverted yield curve should not disrupt the Fed’s rate-hiking agenda — only bad economic data should.
“Although the curve will probably invert at some stage in this cycle, and there will eventually be a recession, we do not expect yield curve inversion due to excessive Fed tightening to cause a recession,” Bhave said.
“Rather, reverse causality will likely be at play.”