THE TREASURY MARKET THROWS A CURVEBALL / THE WALL STREET JOURNAL

The Treasury Market Throws a Curveball

The yield curve is signaling a recession, but the risk still isn’t fully priced in

By Justin Lahart

The Federal Reserve, led by Chairman Jerome Powell, is set to make its latest interest-rate decision this week. / PHOTO: VALERIE PLESCH/BLOOMBERG NEWS

The yield curve is flashing a recession signal, but the still-high level of long-term Treasury yields suggests the bond market itself doesn’t quite believe it. 

That might be a reason to buy Treasurys. 

The yield curve is now deeply inverted, with short-term rates far above long-term ones. 

The yield on the 10-year Treasury note, lately at 3.57%, is 0.76 percentage point below the yield on the two-year note. 

When this happens it has historically been a harbinger of a recession, and the current inversion is far more worrisome than the one that briefly occurred in the spring. 

The inversion clearly signals the market’s belief that the Federal Reserve, which is widely expected to raise its target range on overnight rates by a half-percentage point on Wednesday, will end up weakening the economy to the point it needs to cut rates later.

More worrisome still is that the 10-year yield is now below the rate on three-month Treasurys—something that many economists, including at the Fed, view as a much more reliable recession indicator. 

In the spring, it wasn’t. 

What is striking is that despite these inversions, long-term yields are still high relative to recent history. 

The 10-year Treasury yield has fallen substantially from the 15-year high of 4.23% that it logged in late October but is still higher than the 1.5% where it kicked off the year, and higher than it was for almost all of the economic expansion that stretched from mid-2009 until the Covid crisis struck.

That high yield level can be only partially explained by the even higher level of short-term yields: Strip out the yield on a two-year Treasury note, and a 10-year Treasury would yield 3.4% during years three through 10. 

During the last expansion, this so-called eight-year, two-year forward rate only rarely got so high. 

Likewise, it can be only partially explained by expectations of higher inflation in the years ahead: The yield on the 10-year Treasury inflation-protected security, or TIPS, implies that investors are expecting annual inflation of only about 2.3% over the next 10 years. 

The 10-year TIPS yield, which reflects investors’ real, or inflation-adjusted, rate expectations, is around 1.3%. 

It almost never got that high during the last expansion. 

Even with their recent decline, it seems likely that long-term Treasury yields would be lower still if the Treasury market was discounting a high probability of anything worse than a mild recession, point out strategists at Evercore ISI. 

Unfortunately, that doesn’t mean the yield-curve’s signal isn’t worrisome.

Despite its history of signaling recessions, ascribing perfect accuracy to the yield curve’s forecasting abilities would, of course, be a mistake. 

The yield-curve inversion that occurred in 2019 preceded the 2020 downturn, for example, but “the idea that bond traders foresaw the Covid virus is absurd,” points out Johns Hopkins University economist Jonathan Wright. 

Moreover, considering how anomalous both the pandemic downturn and the subsequent recovery have been, all traditional forecasting tools have to be taken with larger grains of salt right now.

But Mr. Wright is worried about the yield-curve signal nonetheless. 

The increase in short-term rates is being driven by the Fed’s tightening to bring inflation down—something that hasn’t been the case for a long time. 

And the scope of later rate cuts embedded in the bond market indicates an expectation that the central bank will be trying to pull the economy out of a downturn.

Even in the best case, where the Fed guides the economy to a proverbial soft landing in which inflation cools and the labor market loosens but the economy manages to skirt a downturn, one could imagine long-term Treasury yields going lower than they are now, and thus bond prices higher, since somewhere in that sequence investors will probably be worrying a lot more about a recession. 

And in an actual recession, worries about the economy could get even more acute.

Treasurys could look like a haven all over again.