In an economy marked by high inflation, the recent inversion of the U.STreasury yield curve appears to reflect a lag in the Federal Reserve's policy tightening relative to the economic cycle rather than market pricing in a recessionSince 2022, expectations for accelerated monetary policy tightening have led to a substantial rise in U.STreasury yields, with short-term rates increasing more sharply than long-term onesAs a result, the yield curve has flattened significantly, causing certain critical maturity rates to invertFor instance, as of April 8, the yield spreads between the 10-year and shorter maturities, such as the 3-year, 5-year, and 7-year, were reported at -1 basis point, -4 basis points, and -7 basis points, respectivelyNotably, the widely observed spread between the 10-year and 2-year yields also inverted, reaching -5 basis points on April 1, which sparked concerns about a potential U.S

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economic recession.

Historically, the inversion of the 2-year and 10-year Treasury yields is often regarded as a leading indicator of economic recessionSince 1980, the U.Syield curve has inverted seven times, with six of those instances, excluding 1998, successfully predicting subsequent economic downturnsTypically, the interval between the first inversion and the onset of a recession spans 1 to 2 yearsHowever, the situation in 2019 presented a unique case where the outbreak of the COVID-19 pandemic triggered a recession much sooner, condensing the usual timeline to a mere six months.

While the 10Y-2Y spread is frequently cited, it is not the sole gauge for assessing potential recessionsRecently, Federal Reserve Chair Jerome Powell highlighted in a speech to the National Association for Business Economics (NABE) that the Fed pays closer attention to the short-term yield curve when examining the relationship between yield curve inversions and recession risks

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Discussed in various working papers by the Fed, different yield spreads have been analyzed for their predictive reliability for potential economic downturns, with the following two spreads standing out.

The first is the 10Y-3M spread, which, aside from the 10Y-2Y spread, has been a topic of significant interest among market participants and is incorporated into economic recession models by the New York Federal ReserveResearch from the San Francisco Fed has indicated that the 10Y-3M spread possesses superior predictive power for upcoming recessions compared to other yield curvesThe yield on 3-month Treasury bills is highly correlated with the effective federal funds rate, reflecting market expectations regarding policy rates over the next three monthsIn past recessionary phases, the 10Y-3M spread has consistently accompanied inversions seen in the 10Y-2Y spread.

The second key spread to watch is the near-term forward spread, which refers to the difference between the 3-month forward yield on Treasury bills 18 months into the future and the current 3-month yield

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Research by Fed economists Engstrom and Sharpe in 2018 and 2019 demonstrated that this spread can better predict recessions as it effectively captures market expectations regarding policy trajectory in the short term, similar to the implied policy rate expectations derived from federal funds futuresIn contrast, the 10-year yield tends to include more noise from factors like inflation risk premiums, liquidity premiums, and Fed asset purchasing behaviors, making the 10Y-2Y spread less reflective of market expectations for near-term rates.

As of April 8, the 10Y-3M spread widened by 52 basis points from the end of last year, reaching 202 basis pointsLikewise, the near-term forward spread has continued to expand, with the New York Fed's latest data indicating a widening of 111 basis points to 220 basis points since the end of 2021. The persistent widening of the 10Y-3M and near-term forward spreads contrasts sharply with the ongoing narrowing of the 10Y-2Y spread, highlighting a notable divergence among these important yield indicators.

What sets the current yield curve inversion apart from prior episodes is that it has occurred during the early stages of an interest rate hiking cycle

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Typically, previous inversions took place later in such cycles, wherein the Fed would halt rate hikes or even commence cuts following an inversionWhen the market anticipates future economic downturns later in a hiking cycle, the implied lower yields on the 2-year rates would drop below 3-month yieldsThus, if the 10Y-2Y spread inverts, the 2Y-3M spread and near-term forward spreads would also likely narrow or invert concurrently; divergences between various yield spread indicators would be unlikely.

However, in this current situation, the inversion took place after the Federal Reserve's first rate hike in March, suggesting that the Fed's policy actions were lagging behind the economic cycle, necessitating an acceleration in tightening measures to combat soaring inflationThe dot plot released after the Fed's March meeting indicated expectations for seven rate hikes within the year, projecting a median benchmark rate around 1.9% by the end of 2022 and about 2.8% by the end of 2023. Given the steep rate hike path anticipated over the next couple of years, the 2-year Treasury yield surged, while the 3-month yield, due to its short maturity, could only account for one to two potential rate hikes

Consequently, the 2Y-3M spread widened significantly, leading to an expansion in the near-term forward spread, which caused a disconnect between various yield spread indicators.

Current U.STreasury yields, despite some inversions, remain steep overallHistorical trends show that before a recession occurs, actual rates usually invert relative to nominal ratesObserving data back to October 2004 for 2-year TIPS yields (Treasury Inflation-Protected Securities), it becomes apparent that inversions between actual and nominal rates preceded two recessions post-2005. With TIPS being a representative indicator of actual rates, the yield curve remains steep, as the actual yield spread (10Y-2Y) had widened by 26 basis points to 163 basis points from the end of 2021 as of April 8. This increase results from markedly higher short-term inflation expectations compared to long-term forecasts.

As of April 8, market expectations for inflation over the next year surged to 5.74%, while expectations for 2 years were at 4.32%, and only 2.88% for 10 years

The market believes that disruptions caused by the pandemic and geopolitical conflicts are short-lived; as supply-side bottlenecks ease and fiscal stimulus wanes amid tightening monetary policies, inflationary pressures are anticipated to return to normalized levels over the long runHence, using the current negative 10Y-2Y nominal spread as an indicator for predicting economic recessions may be misleading in this context.

Furthermore, it’s important to recognize that an inverted yield curve does not inevitably lead to a recessionThe current yield curve inversion is occurring in a vastly different macroeconomic environment compared to previous episodes, which complicates a straightforward interpretation of yield spread indicators signaling future economic conditionsThe advent of the COVID-19 pandemic in 2020 prompted the U.Sgovernment to implement extremely accommodative monetary policy alongside massive fiscal stimulus measures to support the economy

The Federal Reserve also shifted its policy framework to an Average Inflation Targeting (AIT) strategy, allowing inflation to exceed the 2% target for extended periods to make up for prior shortfalls.

This policy shift emerged against a backdrop of a flattened Phillips Curve since the 1980s, which exhibited a strong labor market yet persistent low inflation—a trend interpreted by the Federal Reserve as an indication that a strong job market may not necessarily lead to runaway inflationHowever, the return of the Phillips Curve to relevance arises from a confluence of factors: prolonged supply chain disruptions from the pandemic, a resurgence in demand fueled by accommodative monetary and fiscal policies, and rising inflation expectations spurred by the Federal Reserve's new monetary policy frameworkCurrent U.Sinflation pressures are substantial, further compounded by the risk of unanchored inflation expectations

With the unemployment rate now at 3.5%, and the February CPI showing a year-over-year increase of 7.9%, the highest in 40 years, there is a palpable real risk of sustained inflation that could deviate from the Fed's target.

It is increasingly clear that the Fed’s updated policy framework has struggled to cope with the post-pandemic macroeconomic environmentThis has resulted in the Fed underestimating the inflationary pressures while also grappling with the potential overheat of the economy due to a vigorous recovery in the labor marketGiven these high inflation conditions, the current U.STreasury yield curve inversion likely reflects the Fed's lagging policy response concerning the economic cycle, rather than signaling an imminent market-driven recession.

Moreover, the Fed has the ability to manipulate the shape of the yield curve through its balance sheet tools

In situations deemed necessary, the Fed could accelerate the balance sheet reduction pace or adjust the maturity structure of its held assetsThis could involve hastening the sale of long-duration assets while gradually selling short-duration assets to raise the term premium on longer rates, guiding the 10Y-2Y spread wider, and restoring a steepened yield curve.

Therefore, it's crucial to approach the relationship between yield curve inversions and economic recessions with a nuanced and rational perspectiveAn inverted curve does not guarantee a recession; under certain conditions where the curve remains steep, the U.Seconomy may transition gradually from an overheating phase to one of slowing growthIn the medium to long term, due to the Fed's limited options to address supply-side constraints, it can only work to suppress aggregate demand as a means of curbing inflation