Current yield curves are sending mixed messages. On one hand, the U.S. 2-year/10-year Treasury yield curve, viewed as a leading economic indicator, appears to be signaling a slowdown in the business cycle. This curve has been flattening of late and inverted for the first time since 2019 on March 31. On the other hand, the U.S. fed funds/10-year Treasury yield curve is signaling the current economic expansion is healthy. It has been steepening in recent weeks and is a positive 184 basis points (bps) through March 31. While there is utility in analyzing the shape of the yield curve, it is not a foolproof indicator.

Over the past 10 years, these two curves have had a strong correlation of 0.90, and yet they now are separated by the widest divergence on record. Is one of these curves simply wrong or an ineffective indicator, or are they both providing valuable takeaways? There may be a few reasons for the divergence:


Figure 1. Yield Curve Spread Comparison, bps
Widest yield curve divergence on record

Figure 1

 

As of 3/31/22 | Source: Bloomberg, L.P.

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2/10 Spread

Think of this yield curve as a market-based report card on monetary policy. As this spread inverts below zero, investors are signaling fears that aggressive rate hikes could tighten financial conditions too fast. Based on fed funds futures, the implied expectation from the market is for a whopping eight rate hikes in 2022. Short-term fixed income investors have already adjusted to these expectations, and the 2-year Treasury is at the highest level since 2019.

Pro: “Predicted” recessions in 1990-1991, 2001, 2007-2009, and 2020.
Con: Predicted recessions by inverting in 2006 and 1998.

Fed funds/10-year Spread

As this curve is one of 10 metrics used in the Conference Board Leading Economic Indicators (LEI) Index, it is viewed as the traditional yield curve indicator from a business cycle perspective. This yield curve initially peaked in March 2021 but is now at its widest spread since early 2016. From a traditional business cycle lens, when this yield curve is steepening, the market is not signaling an imminent slowdown.

Pro: “Predicted” recessions in 1973-1975, 1980, 1981-1982, 1990-1991, 2001, 2007-2009, 2020. 
Con: Predicted recessions in 1998, 1995, and 1986.

While both batting averages would enable entry into the National Baseball Hall of Fame, neither yield curve is a perfect indicator of the future path of the business cycle. We strongly believe yield curves should be viewed as only one tool in the business cycle analysis toolbox. To be sure, the cycle is slowing due to several reasons: inflation is the strongest in 40 years, the Ukraine conflict remains an unknown for global markets and impacts from the two-years-and-counting pandemic have yet to fully resolve. However, we are still seeing positive revisions for 2022 earnings, the labor market is still recovering, and most global leading economic indicators still point to a slowing but growing path forward. Therefore, we believe the combination of the two yield curves suggests the business cycle is not facing imminent collapse, but rather monetary policy is in a delicate position of needing to curb inflation without stifling growth — not an easy task! 

Planning to Plan

It is important to note, flat does not equal inverted, which is the typical signal of a recession. A yield curve can stay flat for an extended period without recession. For example, the 2/10 curve averaged 47 bps for three years in the mid-1990s, and in 1999, which was one of the best years for stocks on record, it averaged just 21 bps for the entire year! From a global perspective, the yield curve for Japan has averaged 18 bps over the past five years.

Figure 2. Japan 2/10 Spread
Japan’s yield curve: Waiting for Godot

Figure 2

 

As of 3/31/22 | Source: Bloomberg, L.P.

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What do we expect to happen if yield curves stay flat or invert? History has shown not only is the yield curve an imperfect measure of contractions in the cycle, but also the time until the market peaks has averaged well over a year. In other words, the yield curve is usually correct that a slowdown is going to happen at some point, but the timing of such an event is imprecise.

Figure 3. Timing of Recessions and Market Peaks Following Inversion
Historically speaking, there is a long lead time once curves stay inverted

 

After 2/10 Curve Inverts

After Fed Funds/10-Yr Curve Inverts

 

Months until Recession

Months until
Market Peak

Months until Recession

Months until
Market Peak

2019

7

7

11

11

2006

23

21

11

15

2000

13

8

12

5

1989

18

18

18

17

Average

15.3

13.5

13.0

12.1


Source: Bloomberg, L.P.

Where Do We Go From Here?

Until the yield curve lines up with the other components of our business cycle analysis, we believe the shape of the curve and the absolute level of interest rates have more bearing on another component of our investment process, valuation analysis. For example, when the yield curve is flattening and interest rates are well below their historical average, it creates a negative term premium for fixed income. In addition to supporting credit spreads in high yield bonds, negative term premiums are also a key tailwind for high valuation equities.

During periods when the yield curve accurately forecasts an economic slowdown, the business cycle tends to still have a significant amount of time left, as does the market. As such, we believe investors should avoid the urge to get defensive with portfolio positioning simply because the 2/10 yield curve is inverting. While there was a quick seven-month period between the last yield curve inversion and subsequent sharp but short recession, we believe it is an exception due to a one-in-a-hundred-year pandemic. There are still plenty of positive economic catalysts despite the inverting 2/10 yield curve. The outlook for earnings is promising, as the S&P 500® earnings growth for 2022 is sitting at a healthy 9.2% growth rate. In fact, in the post-World War II era, there has never been an economic recession without an earnings recession. Compared to the progression of earnings estimates in 2019, when both yield curves were last inverted at the same time, the diverging paths of the two are certainly telling us to keep close watch on monetary policy as the business cycle continues to grow at a healthy pace.

Figure 4. S&P 500 Estimated Earnings Growth (%)
Current earnings growth estimates remain healthy versus 2019

Figure 3

As of 3/31/22 | Source: FactSet®. FactSet® is a registered trademark of FactSet Systems Inc., and its affiliates.

 

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Accessible Version of Charts

Figure 1: Yield Curve Spread Comparison,bps

Widest yield curve divergence on record (view image)

Date 10Y - Fed Funds Spread 10Y - 2Y Spread
3/31/1996    107.7 60.15
3/31/1998 20.6 14.3
3/31/2000 5.5 -42.35
3/31/2002 364.6 181.35
3/31/2004 289.39 227.35
3/31/2006 10.51 2.283
3/31/2008 119.14 179.3
3/31/2010 360.66 279.915
3/31/2012 195.88 187.996
3/31/2014 247.08 226.72
3/31/2016 132.28 106.218
3/31/2018 98.89 46.879
3/31/2020 47.64 49.441
3/31/2022 184.88 3.647


Figure 2. 
Japan 2/10 Spread
Japan’s yield curve: Waiting for Godot  (view image)

Date Japan 2/10 Average 
3/15/2018 19.7 18.497
3/15/2019 13.3 18.497
3/31/2020 18.6 18.497
3/15/2021 25.6 18.497
3/31/2021 23 18.497
3/15/2022 24.5 18.497
3/31/2022 26.9 18.497
3/15/2018 19.7 18.497

 

Figure 3. Timing of Recessions and Market Peaks Following Inversion
Historically speaking, there is a long lead time once curves stay inverted

 

After 2/10 Curve Inverts

After Fed Funds/10-Yr Curve Inverts

 

Months until Recession

Months until
Market Peak

Months until Recession

Months until
Market Peak

2019

7

7

11

11

2006

23

21

11

15

2000

13

8

12

5

1989

18

18

18

17

Average

15.3

13.5

13.0

12.1

Figure 4. S&P 500 Estimated Earnings Growth (%)

Current earnings growth estimates remain healthy versus 2019 (view image)

Number of Weeks Since EPS Estimates Began 2019 EPS Growth Rate (%) 2022 EPS Growth Rate (%)
1 9.8 7.0
11 9.7 8.8
21 9.6 14.0
31 9.9 14.6
41 10.4 15.8
51 10.4 16.5
61 9.9 15.2
71 10.1 11.8
81 10.2 10.6
91 7.6 9.4
101 4.4 8.3
111 4.1 8.3
121 2.7  
131 1.9  
141 0.8  
151 1.0