The U.S. yield curve is steepening again – so what?

Chart of the week

The U.S. yield curve inverted last August, foretelling the current recession. But its recent steepening does not necessarily indicate that the recession will end soon.

The S&P 500 has pretty much made up its previous losses. For about three weeks now, value stocks have been outperforming growth stocks. And in real life, traffic jams are back. An economic recovery is in the air. Is this assessment confirmed by the queen of all leading indicators – the yield curve? Last August 10-year U.S. Treasury yields sank below the 2-year yields. The U.S. yield curve, in other words, inverted and slid into negative territory. That caused a lot of excitement. After all, each of the nine U.S. recessions since 1955 was preceded by an inverted yield curve. As our "Chart of the Week" shows, it has now worked for the tenth time: on Monday, the National Bureau of Economic Research officially declared the end of the U.S. economic expansion as of February. 

Some might object that this was all just a coincidence, since no one could have foreseen the Covid-19 pandemic last summer. However, the global expansion had been somewhat anaemic for some time. DWS's own recession indicator already showed a recession probability of around 50% at the beginning of 2020. In other words, a recession in the United States was partly in the air and Covid-19 was only one of many possible triggers. Moreover, experts have been warning of such a pandemic for some time. The fact that equity markets only began to panic in mid-February perhaps says more about markets than the actual economic risks. After all, part of the reason that inverted yield curveshave become such a widely used recession indicator is that sovereign-bond markets tend to be more reliable than the mood swings in equity markets. 

So if the forecast of a recession through the yield curve was not purely a lucky strike, could its steepening be predicting the end of the recession? According to past patterns, a steepening is quite consistent with the recession continuing for a bit longer. But first of all, less than a dozen observations are a bit thin as a historic data set to derive timing predictions from. Second, the – global – reaction to the recession in the form of government aid packages is of unprecedented dimensions. And third, central banks are also expanding the quality and quantity of their interventions in the form of negative interest rates, credit guarantees[1] or corporate-bond purchases. The last resort is yield-curve control – which Japan has already implemented and which the U.S. Federal Reserve (Fed) is currently discussing. If central banks set themselves the goal of directly controlling most of the yield curve, the bond market will be robbed of its pricing function. And with it the mechanism that should enable the efficient allocation of scarce resources to the most promising investments. Then again, money is no longer a scarce resource anyway.

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Sources: Federal Reserve Bank of St. Louis, NBER the National Bureau of Economic Research, DWS Investment GmbH as of 6/5/20

1. Promise by a third party to provide payment on a liability in the event of default.

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