A Tale of Two Curves

06 May 2022

This content is for professional investors only as defined by the MiFID.

Trying times of inflation, heightened geopolitical conflicts and other challenges can drive equity investors to focus on the yield curve as a potential indicator of the economy’s future health. Many market observers, it appears, believe even a brief yield curve inversion is an indication that a recession is likely. Which curve should investors be focused on today?

Traditional Yield Curve vs. New Yield Curve

  • The power of the yield curve in forecasting recessions rests on the bond market’s forecast of interest rates. When bond investors believe the economy is in trouble, they anticipate a decline in interest rates, which lowers the longer end of the curve, potentially below the near-term part of the curve, resulting in inversion.
  • The traditional 10-year bond yield less the 2-year yield is somewhat of a crude approximation of interest rates in the future versus more near-term rates. This indicator recently pointed to potential recession as illustrated by the teal line above.
  • A more exact forecast, the Federal Reserve (The Fed) argues, can be gleaned by comparing the forward 3-month yield 18 months in the future as compared to the current 3-month yield. As illustrated by the blue line, it turns out that this curve is very steep and is indicating the potential for growth ahead.
  • The fact that the bond market believes the Fed will be able to raise short-term interest rates significantly over the next 18 months implies the potential for a healthy economy, which is a very different and more optimistic picture than the more traditional yield curve.

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