Fixed income perspective – from the Investment Advisory Group

Fixed Income Perspectives

March 10, 2022

Yield signals – U.S. fixed income signaling caution, not panic

Executive summary

Over the past half-century, U.S. fixed income markets have served as a reliable barometer for the U.S. economy and financial conditions. In the wake of Russia’s aggression in Ukraine and the resultant turmoil in commodity markets, bond markets have recalibrated quickly to heightened global risks and uncertainty. As a result, several bond market indicators—the U.S. yield curve, credit spreads, volatility, and liquidity—appear less confident about the future state of the economy. However, at this point, each of these measures is signaling caution, not panic in our view.

What happened

While concerning and worthy of close surveillance, the aforementioned indicators have yet to sound alarm bells.

U.S. yield curve – Yield curve inversions -- when longer-dated yields fall below shorter yields -- have presaged every recession for the last half-century. Typically, a yield curve inversion has forerun a recession by roughly 6 to 18 months, with a notable false alarm in 1998 which wasn’t accompanied by a recession. The two primary segments of the U.S. Treasury curve used for recessionary signals are: the spread between 2-year and 10-year yields and the spread between 3-month and 10-year yields. These spreads highlight the relationship between Fed policy accommodation (reflected in short yields) and growth and inflation expectations (tied to longer-dated yields).

The 3-month/10-year curve is more reflective of this policy and economic balance in real time. Given its short investment horizon, 3-month yields tend to reflect Fed policy rates over the very near-term. This spread currently sits at 1.55%, but we expect this spread to narrow (or flatten) as the Fed raises rates starting next week. However, by this measure, the Fed has ample room to tighten its policy stance without threatening a curve inversion.

The 2-year/10-year yield curve offers the Fed far less breathing room. This segment of the curve is more forward-looking by nature with 2-year yields accounting for policy rates further into the future. The 2-year/10-year spread is currently hovering near 0.25%, having flattened by 125 basis points (1.25%) since last March. This move is bringing the threat of a yield curve inversion – and its recessionary signal – to the forefront of investor’s minds. While a concern, the 2-year/10-year curve has yet to invert in this cycle. The shape of the yield curve suggests the Fed should remain cautious and data-dependent with respect to rate hikes. Additionally, above trend growth, high inflation, and Fed balance sheet reductions should each contribute to higher intermediate and long U.S. yields, which should encourage a healthier curve.

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