The outlook for the U.S. economy has brightened considerably in recent weeks, but the Treasury yield curve remains near its most deeply inverted level in at least four decades.
Why? A team of bond-market strategists at Goldman Sachs has a potential answer. In a note to clients published Wednesday, interest-rate strategists Praveen Korapaty and William Marshall said that, contrary to popular belief, the deeply inverted Treasury yield curve could be signaling that recession odds are declining, not rising.
They based their view on a model of the yield curve that, they said, suggests traders are making outdated assumptions about things like the natural equilibrium level of interest rates in the economy, a wonky economics concept formally known as “r*.”
One reason bond traders have pushed up these yields, which move inversely to bond prices, to such a substantial degree is that investors are still assuming a rate for r* that is far too low.
“Investors appear to be wedded to the secular stagnation, low r* view of the world from the last cycle. We believe this cycle is different, with an economy that can support a higher long run real rate than currently assumed,” the strategists said in their note.
If this holds true, it would mean that “[i]n a mechanical sense….deepening inversion seems to have the opposite implication for recession odds than commonly ascribed,” the team wrote.
Treasury yield-curve inversions have reliably predicted the arrival of recession. The three-month to 10-year curve, seen as the most accurate of the various yield-curve spreads used by traders and strategists, has inverted ahead of every U.S. recession since at least the 1980s, according to data from the St. Louis Federal Reserve.
The Goldman strategists aren’t alone in doubting the yield curve’s messaging. Campbell Harvey, the Duke University finance professor who helped pioneer the use of the yield curve, recently told MarketWatch that he thinks the gauge is sending a “false signal” this time around.
Others have pointed out that while an inverted yield curve has historically portended economic pain to come, U.S. equity markets have typically avoided lasting weakness.
The 2s10s yield curve inversion stood at 80 basis points as of Wednesday afternoon in New York, according to Dow Jones Market Data. The 3m10s inversion stood at 105.4 basis points. The 3s10s yield curve reached its most-inverted level ever on Jan. 18, when the spread between the 3-month Treasury bill yield and the 10-year Treasury note yield fell to -127.7 basis points.
When a yield curve is inverted, it means that investors are demanding higher returns to lock up their money for a shorter amount of time. Such a dynamic is seen as a sign that investors expect rocky economic times ahead.
On Dec. 7, the 2yr10yr spread fell to a cycle low of -84.9 basis points, the most inverted level since October 1981, per DJMD.
The yield on the 2-year Treasury note
stood at 4.429% Wednesday afternoon in New York. By comparison, the yield on the 10-year note
stood at 3.638%.