Why the yield curve isn’t signalling recession

Published on15 SEP 2023

The yield curve — the difference between yields of 10- and two-year US Treasuries — has long been seen as a predictor of recession: When investors are fearful, they tend to buy up 10-year Treasuries, causing the yield to fall below the interest rate of shorter-term securities. 

But that’s not what’s happening now. For one thing, longer-term Treasury yields have risen as financial markets price in a lower chance of recession, says Ashok Varadhan, co-head of Global Banking & Markets at Goldman Sachs, in The Markets podcast. “Unbelievably resilient is the way I would characterize the US economy,” Varadhan says, noting that Goldman Sachs Research recently lowered its probability for a downturn.

When it comes to the yield curve, Varadhan says it’s not so much that 10-year yields are low — they’ve climbed to around 4.3%. Rather it’s that the Federal Reserve’s policy rate is relatively high. In an effort to tamp down inflation, the central bank has ratcheted up its target rate to 5.25% to 5.5%.

As a result, Varadhan says policy rates are restrictive. He says one way bond market participants look at that is by comparing inflation, which is at around 3%, to the Fed’s policy rate of more than 5%. That inflation-adjusted rate, or real rate, is around 2%. That’s a switch, as real rates have often been negative in recent years. “That’s in the arena of being restrictive,” Varadhan says.

Bond investors, meanwhile, likely expect the central bank’s policy rate to eventually go back to a more neutral, long-term rate of around 3.5% as inflation cools in the coming years. “People believe that will mean revert over time,” Varadhan says. “Therefore, that's what's driving the inversion.”

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