The difference between 10-year and 3-month U.S. Treasury yields has narrowed since the start of this month (Figure 1), amid hopes that the Federal Reserve will reduce its target federal fund rate at its next meeting on 30-31 July. For economy watchers, it tells them something about the outlook of the U.S. economy.
This yield spread is watched closely to check the pulse of the United States’ economic health. When the economy is healthy, price levels are expected to rise, and the 10-year yield is normally higher than 3-month yield as investors anticipate a bigger reward for the greater uncertainty that they face over a longer horizon.
However, for the past few months we have seen the 3-month yield rising above the 10-year yield, creating an “inverted” yield curve and stoking fears about a possible economic downturn. Investors have every reason to worry about this, as a yield curve inversion lasting for more than a month preceded every single U.S. recession in the past 50 years.
But what does an inverted yield curve really mean? It tells us that short-term rates are higher than long-term rates. In essence, it reflects the market view that short-term rates, which are largely determined by adjustment of the target federal fund rate by the Federal Reserve, are too high; and that economic growth and inflation are not sustainable and are likely to drop in the future.
Economic data in the U.S. has been mixed. In June, job growth was strong, with non-farm payrolls increasing by a net 224,000, the largest addition of jobs since January. Despite robust employment, inflation pressures remain tepid with core personal consumption expenditures price index hovering around 1.6% in June. Meanwhile, the Purchasing Managers’ Index published by the Institute for Supply Management, a gauge of U.S. manufacturing activity, fell to 51.7, the lowest level since October 2016 and close to the sub-50 level of contraction.
A short-term inverted yield curve does not necessarily mean there will be a recession, but it is definitely a warning sign for the U.S. economy. It is all the more worrying when you consider it comes at a time when the global economy is slowing, and there is no end in sight to the China-U.S. trade war. In general, the longer the curve is inverted, the higher the danger of an economic downturn. Given that the Federal Reserve is set to relax its monetary policy very soon by cutting interest rates, with the yield spread becoming less negative, the likelihood that the U.S. economy will tip into recession in the near term is smaller, though the threat cannot be totally ignored.
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