(The opinions expressed here are those of the author, a columnist for Reuters.)
By Jamie McGeever
LONDON, April 17 (Reuters) - The benchmark U.S. yield curve hasn’t inverted yet, meaning any talk of recession will be shot down rapidly and forcefully.
But more esoteric U.S. interest and swap rate curves have already turned negative, which some analysts say is a warning sign the more closely watched gap between the two- and 10-year yields could go the same way.
And when that happens, recession follows sooner or later.
One of those indicators is the forward curve for the one-month U.S. Overnight Index Swap (OIS) rate, a proxy for the Fed policy rate, which JP Morgan analysts note has inverted slightly after the two-year forward point.
This implies that investors are expecting the Fed to cut rates as early as the first quarter of 2020. There are two potential explanations for this: Markets have started pricing in a Fed policy mistake, or they have started pricing in end-of-cycle dynamics.
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“An inversion at the front end of the U.S. curve is a significant market development, not least because it occurs rather rarely. It is also generally perceived as a bad omen for risky markets,” they wrote in a recent research piece.
George Saravelos at Deutsche Bank offered up a similar take earlier this week but cited a different curve. He pointed to the spread between “3y1y and 2y1y” U.S. swap rates, i.e. where the market expects 1-year rates to be in 2020 and where they expect them to be in 2021.
Saravelos notes that this spread has inverted, signaling that investors expect the Fed will end its hiking cycle some time in 2020.
“The market is pricing cuts! The market is already pricing the end of the Fed hiking cycle and the beginning of some easing,” he wrote.
Inverted interest rate or yield curves should be anomalous. A 10-year yield should be higher than a two-year yield, as it reflects the extra credit, inflation and other risks investors take on when lending for 10 years rather than two.
Any number of rate or yield curves can be constructed, but the “2s/10s” yield curve is widely seen as the benchmark. It is currently the flattest it has been for over a decade and has been flattening for more than four years. It’s just 45 bps away from inverting.
The curve has gone flatter than that eight times in the past four decades: late 1977, August 1980, December 1981, July 1984, late 1988, late 1994, mid-1995 and May 2005.
Curve inversion followed on six of those occasions, and the economy fell into recession every time. In some respects the late 70s and early 80s inversions merged into one. The curve was inverted for much of 1978-82, during which time there were two separate recessions.
There’s little evidence that a flattening curve itself is correlated with a slowing economy, however, and analysts have offered several reasons why there is no cause for concern this time around. They include: persistently low inflation, a decade of QE compressing yields and forcing investors into the long end of the curve, and U.S. Treasury funding-related debt issuance quirks.
But history shows an inverted curve is a cast-iron recession predictor. And that’s only 45 basis points away.
Reporting by Jamie McGeever Editing by Hugh Lawson