The yield curve un-inverts. Is that good news?

On 5 August the gap between two-year and ten-year Treasury yields briefly turned positive, for the first time since July 2022. Casual commentators tend to greet the end of an inversion as a return to normal. The historical record says otherwise.

A panic, then a flip

The flip came on one of the most violent days in markets for years. The July jobs report, published the previous Friday, showed unemployment rising to 4.3 per cent and triggered the Sahm recession rule. The Bank of Japan's rate rise on 31 July had already set off a scramble out of carry trades funded in cheap yen, and on 5 August Japan's Nikkei 225 suffered its largest one-day fall since 1987. Investors piled into short-dated Treasuries, betting that the Fed would have to cut quickly and perhaps deeply.

Two years upside down

The inversion itself was unusually long and deep. It began in July 2022 as the Fed raised rates at the fastest pace in four decades, and at its deepest, in the summer of 2023, the ten-year yield sat more than a full percentage point below the two-year. The recession it was supposed to foretell has not arrived. Many investors have concluded that the signal is broken.

There are good reasons why the economy withstood the inversion for so long. Households and companies locked in very low fixed borrowing costs in 2020 and 2021, when mortgage rates and corporate bond yields hit record lows, so higher policy rates reached them slowly. Large federal deficits kept pumping money into the economy, and savings built up during the pandemic cushioned consumer spending. Those buffers delayed the usual effect of tight money without abolishing it, and most of them have now thinned.

Why steepening can mean trouble

When the curve un-inverts because short-term yields are collapsing, a move known as a 'bull steepening', recession has usually been close. The curve rights itself because markets are rushing to price in emergency rate cuts as the economy weakens. The danger has historically come when the curve snaps back to a positive slope, well after it first inverted.

The mechanism runs through the two-year yield, which is little more than the market's forecast of the average policy rate over the next two years. When traders conclude that the Fed must cut, that yield falls faster than the ten-year, which is anchored by longer-run expectations of growth and inflation. So the curve steepens just as the outlook darkens. Inversion signals that tight policy is biting, and un-inversion signals that the Fed has noticed.

What history shows

The past three cycles fit the pattern. The curve inverted in 2000, steepened as the Fed began cutting in January 2001, and recession began that March. It inverted again in 2006 and 2007, steepened from the middle of 2007 as the Fed started cutting that September, and recession began in December 2007. In 2019 a brief inversion gave way to steepening shortly before the pandemic recession of 2020, although no bond market can claim to have forecast a virus.

There is a gentler precedent. In 1998 the curve flirted with inversion during the Russian default and the collapse of Long-Term Capital Management, the Fed cut three times, and the expansion carried on for more than two years. A curve can also steepen without a recession if the Fed trims rates from a high level while growth holds up, and with output growing at an annualised 2.8 per cent in the second quarter that remains possible. The difference will show up in the labour data first.

Winners from a steeper curve

Whatever the cause, a positive slope shifts money between sectors. Banks borrow short and lend long, so an inverted curve squeezed their margins, and the regional lenders that suffered most in the deposit flight after Silicon Valley Bank failed in March 2023 stand to gain most from its reversal. Holders of short-dated bonds and money-market funds, who were paid handsomely to wait during the inversion, lose that advantage as the Fed cuts. Borrowers on floating rates, from small firms to credit-card users, gain as short rates fall, while those who need long-term finance, such as housebuilders and mortgage borrowers, gain less, because long yields are falling more slowly.

Equity markets are the harder case. Cheaper money supports valuations, but if the steepening reflects a weakening economy, earnings forecasts will fall, and cyclical shares have historically suffered in the months around the first cut of an easing cycle that ended in recession.

Signals to watch

The August payrolls report in early September, weekly jobless claims and the Fed's meeting on 17 and 18 September will show which story is right. A curve that steepens because long yields rise, on fears about deficits and inflation, carries a different message from one that steepens because the two-year yield keeps falling. Only the second is the classic recession signal, and it is the one on display in early August.

Borrowers tied to short-term rates stand to gain from cuts either way, but equity investors who read the move as reassurance are drawing the wrong lesson. A normal-looking yield curve is no all-clear. It usually means the Fed is easing because the economy is in trouble, and investors should treat the un-inversion as a warning that a slowdown may be only months away. If the curve stays positive through the September meeting on the back of a falling two-year yield, expect weaker hiring by the winter, with cyclical shares and lower-rated corporate borrowers the first to feel it.