Update on "The Yield Curve Puzzle" and Inflation
A Recap: The Yield Curve Puzzle
In our previous AIBC 2022 article "The Yield Curve Puzzle", we discussed the US yield curve inversion and its implications for investors. For a quick summary, the yield curve is an extended chart that plots the yields of bonds with different maturities. Under normal economic circumstances, the yield curve tends to be upward-sloping as investors tend to demand higher risk premiums for long-term bonds (10yr, 20yr, 30yr bonds etc). However, when investors anticipate a prolonged economic recession, they demand higher yields on shorter-term bonds, causing the yield curve to invert. An inverted yield curve is often seen as a sign of an impending economic recession, as it indicates that investors are more concerned about the short-term risks of a slowing economy. The US Treasury yield curve has been inverted since April 2022, reflecting a mixed view of the markets towards continued recession and inflation risks.
Figure 1: US treasury yield curve as of July 2023
Two interpretations of this yield curve inversion that we discussed in the past article were: negative spreads reflecting expectations of an upcoming economic downturn, and reflecting rising market stress and preference for safer and more liquid assets. We also established that although yield curve inversion may signal an upcoming economic recession, the fundamental explanations behind this theory may no longer hold given the structural changes that have taken place in the underlying US Treasury market and global financial landscape in recent years.
As of July 2023, the US yield curve continues its inverted form to a greater extent, in which investors demand even higher yields on shorter-term bonds. To further elaborate on the extent of a yield curve inversion, we can analyse the 10-2 year treasury yield spread as an indicator.
Figure 2: US 10-2 year treasury yield spread
The 10-2-year treasury yield spread is a financial indicator that compares the yields of two different types of US Treasury securities: the 10-year treasury bond and the 2-year treasury bond. When the yield curve is steep and the difference between the yields of the 10-year and 2-year bonds is large, it implies that investors are optimistic about the future state of the economy. Hence, they expect higher economic growth and inflation in the future. As investors are optimistic about the economy's future prospects, the demand for longer-term bonds increases, giving upward pressure on its yield. Meanwhile, demand for shorter-term bonds such as the 2-year bond remains relatively stable, keeping its yield low.
On the other hand, when the yield curve is inverted as seen in the recent US treasury market, the difference between the yields of the 10-year and 2-year bonds is small or negative. In this particular circumstance, investors may prefer to invest in shorter-term bonds such as the 2-year bond as a way to protect their investments from possible future interest rate decreases, which could decrease the value of longer-term bonds.
The spread between the 10-year treasury yield and the 2-year treasury yield (calculated by 10 years - 2 years) has been negative for the past year. However, in 2023 July, it hit a record-breaking lowest number since 1982 and showed the widest spread in more than four decades, implying that the yield curve has reached its most inverted state since 1982. This can be regarded as a warning sign for the economy, as it suggests that investors are more concerned about the short-term outlook than the long-term outlook.
CPI and Inflationary Expectations in Jan 2023
Figure 3: US 12-month percentage change in Consumer Price Index
Inversion of the US yield curve can also be directed to the ongoing higher inflationary expectations and the rising Consumer Price Index (CPI). CPI is a key economic indicator that measures the average change in prices of goods and services consumed by households. It is used by policymakers and investors to gauge inflation, which is defined as the general rise in the price level of goods and services over time. Inflationary expectations, or the expected rate of inflation in the future, are crucial for economic decision-making, such as for the setting of interest rates by the Fed. Due to consistent interest rate hikes, the CPI has been declining recently, but at a slower pace than expected pace.
Regarding January 2023 CPI data, the actual CPI (6.4%) was higher than the projected (6.2%) estimate provided by economists. This meant that CPI had only declined by 0.1% compared to the previous month, therefore proving the notion that we entering a period of disinflation, where the inflation rate is declining, but at a slower pace. The Fed will continue to pay attention to PCE (core inflation) in 2023, which is expected to remain high at 3-4% throughout 2023 and into 2024.
Views on US Recession and Yield Curve Inversion
As of July 2023, the US Recession Probability for June 2024 was 67.31%, which has increased significantly compared to historical US recession probabilities. This means that we are in an uncertain macroeconomic environment where high volatility may return.
Figure 4: US recession probability index
However, The Street remains mixed on whether a recession would actually occur. Morgan Stanley posits a more bearish view, stating that as inflation reaches 40-year highs, the probability of a US recession has increased significantly. Goldman Sachs, on the other hand, stated that there are pieces of evidence why the US can avoid a recession in 2023, most importantly the persistent strength in the labour market and early signs of employment improvement in business surveys.
As the US is one of the largest economies in the world with its economy representing around 25% of the world's GDP, any significant changes in the US economy will have a significant impact on the global economy and financial institutions. Hence, keeping an eye on this trend and its implications would be vital to understand the market.