Interest rates in the United States have had very important movements along the entire curve in recent months. In the short-term part, the Fed increased the funding rate from 0 to 0.25% two weeks ago.
However, the two-year bond rate has risen from 0.85% to 2.33% so far this year, discounting that the Fed will raise rates by at least 2 percentage points in the next 12 months. In the long part of the curve, the rate paid by the 10-year Treasury bond has increased from 1.51 to 2.35% in the same period.
As is evident, the rate paid by the 10-year bond and the two-year bond are practically identical. However, in the trading session on Tuesday, the rate on the 2-year bond was higher than the 10-year bond for a few minutes.
Historically, the interest rate curve has a positive slope, that is, short-term rates are usually lower than long-term rates. This happens because, in theory, the risk of lending money in the long term is greater than in the short term and therefore investors require a higher return.
However, in reality, there are occasionally periods when the rate curve does not have a positive slope. On some occasions, the curve is flattened, that is, the short and long-term rates are similar.
On other occasions, the curve inverts, that is, short-term rates are higher than long-term rates. An inverted curve is a rare phenomenon and has traditionally been a harbinger of recession.
A study by the San Francisco Fed published in 2018 reveals that each of the nine recessions that occurred in the United States between 1955 and 2018 were preceded by an inversion in the rate curve. The study also shows that, with the exception of a false positive in the mid-1970s, every episode in which short-term rates have been higher than long-term rates has been followed by a recession.
The last time the yield curve inverted was in 2019 and in less than a year the US economy was in recession. However, this recession was not cyclical in nature as it was precipitated by an exogenous shock with the arrival of the pandemic.
Before the 2019 episode, the last time the curve was inverted was in 2006 and 2007. In those years, the curve was inverted for several months and the US economy entered a recession in the second half of 2008.
The inversion in the curve raised this week was momentary in nature and few specialists see it as a harbinger of an inevitable recession in the next 24 months. However, the vast majority agree that the flattening of the curve and brief reversal herald a significant slowdown.
This is not news to anyone, the Fed has just revised down its growth forecast for the US economy from 4 to 2.8 percent. The American economy still has a high chance of avoiding a recession and that everything ends up in a slowdown, but this will depend, to a large extent, on the ability of the Fed to restrict its monetary policy, with the aim of controlling inflation, without detonating a recession
A couple of weeks ago, the Fed gave the market a signal that it could raise rates seven times this year and another three in 2023, to leave the funding rate at 2.8% at the end of 2023. However, the market has begun to discount a more aggressive path of hikes that could leave the rate closer to 3.5% by the end of 2023.
It is very likely that inflation will begin to ease in the medium term as a result of the tightening of monetary policy and the consequent slowdown in growth. However, it is very likely that the inflation levels for the next few years will be higher than what we have seen during the last 10 years.
This should contribute to long-term rates also having a significant upward movement in the coming months. Additionally, the reduction of the Fed’s balance sheet, which should begin in the second half of the year, will imply the sale of a significant volume of long-term instruments.
Although the Fed is likely to be very cautious with the pace and volume of decumulation of financial instruments, this dynamic should also contribute to long-term rates rising and the yield curve maintaining a positive or flat slope in the worst case.
The brief inversion of the yield curve seen this week seems to be a false alarm of a recession, but given the historical background, it is an indicator that we should not lose sight of.
Managing Partner of EP Capital, SC
Without Borders
Joaquín López-Dóriga Ostolaza is the Managing Partner of EP Capital, SC, a consultancy specialized in mergers and acquisitions founded in 2009.
He is a graduate of the Bachelor of Economics from the Universidad Iberoamericana, where he graduated with honors and the highest average of his generation. He has a Master’s degree in Economics from the London School of Economics, where he was awarded the British Council Chevening Scholarship Award.