Follow the Curve, Not the Noise

June 17, 2022

From the desk of Steven Strazza @Sstrazza and Ian Culley @Ianculley

Now that inflation is no longer transitory and we’ve officially entered bear market territory, "recession" is the next buzzword on deck.

And don’t worry: Plenty of banter surrounding the yield curve will take center stage during all this recession talk.

Somehow, an inverted yield curve has become synonymous with recession even though the historical record supporting this narrative leaves room for plenty of interpretation.

The purpose of this post is not to present an argument on whether we’re already in a recession or if one is imminent. We’ll leave that up to the talking heads and economists.

Instead, we'll simply share where the yield curve is today and assess the likelihood of potential inversion.

Let’s take a look…

Here’s a triple-pane chart of the US 30-year, 10-year, and 5-year yields:

All three yields pictured above hover around 3.40 to 3.50%. And the 2-year isn’t far behind.

Currently, the yield curve is flat as a pancake and looks ready to flip.

This would make sense as the shorter end of the curve should keep moving higher based on the Federal Reserve's plans to keep hiking.

And with growth slowing in the US, the longer end of the curve is likely to come under pressure.

This is how inversions happen.

While yesterday’s Federal Open Market Committee decision to hike the federal funds rate by 75 basis points came as no surprise, these yields all edged lower as the curve went relatively unchanged.

Interestingly, even the 2-year and the 3-month yields -- which along with the 10-year comprise the spreads used for calling recessions -- have been lower following the announcement.

As such, the 2s/10s spread and 3mo/10s haven’t moved much.

This may be the case for now. But if the Fed follows through with its forecast hikes, the 2-year and the 3-month are going to rise, and those spreads will contract and invert as they do.

With a flattening curve and an accelerating rise at the shorter end, it seems more a matter of "when," not "if," we get an inversion.

We’re already seeing the curve invert across longer durations. Here’s a chart of the 10s/30s, 5s/30s, and 2s/30s spreads:

The 10s/30s and the 2s/30s are back in positive territory after briefly turning negative earlier in the week. But the widely watched 5s/30s remains inverted.

With other areas of the curve already inverted, most yields holding near the same levels, and an aggressive Fed fueling an acceleration at the short end of the curve, we think there’s a high likelihood that the 2s/10s inverts for the second time this year.

We don’t know if it will be tomorrow or next week. But it’s likely to happen soon.

Don’t be surprised when a flurry of headlines and tweetstorms hailing the next recession come raining down.

We’ll be right here focusing on the price action and ignoring all that noise when it happens.

Countdown to FOMC

The market is pricing in a 75-basis-point hike at the July meeting after yesterday's triple hike.

Here are the target rate probabilities based on fed funds futures: