Guo Yingfeng: How to Interpret the Inversion of U.S. Treasury Yields

—By Guo Yingfeng (Associate Researcher, China Center for International Economic Exchanges) 

Against the backdrop of the market widely expecting the Federal Reserve to continue raising interest rates by 25 basis points (BP) this month, on July 3rd, the yield curve of U.S. Treasury bonds approached the historical high point of nearly forty years set in March of this year. The yield on two-year U.S. Treasury bonds reached 4.96% at one point, surpassing the yield on ten-year Treasury bonds by 110.8 basis points. This indicates that the current market is digesting expectations of further rate hikes by the Federal Reserve, reflecting that the pace of decline in inflation and employment data in the United States has not yet satisfied the decision-makers.

The inversion of the U.S. Treasury yield curve is caused by the Federal Reserve's interest rate hikes and is an intermediate result of the transmission of monetary policy. It should be noted that every interest rate hiking cycle by the Federal Reserve does not necessarily lead to an inversion of the U.S. Treasury yield curve. Since March 2022, the Federal Reserve has raised interest rates continuously for ten times, accumulating a total of 500 BP in rate hikes. From the perspective of the transmission channels of monetary policy, the phenomenon of yield curve inversion is an intermediate result of the Federal Reserve's interest rate hikes and is part of monetary policy. Historical data also shows that the inversion of the yield curve of U.S. Treasuries generally occurs in the later stages of a rate hiking cycle. Therefore, the current inversion of the U.S. Treasury yield curve suggests that this round of interest rate hikes by the Federal Reserve is entering its final stage, with an expectation that it will end by the end of this year at the latest.

The inversion of the yield curve is only a market signal of the Federal Reserve's interest rate hiking cycle and does not necessarily indicate that the U.S. economy will enter a recession. Typically, when the federal funds rate is raised continuously, it may lead to an excessive contraction of the U.S. economy, causing a recession. In other words, the risk of an economic recession caused by the Federal Reserve's consecutive rate hikes is increasing. Based on this logic, investors usually interpret this as a signal of an upcoming economic recession, as has been verified in history. However, the yield on government bonds is a sensitive indicator reflecting market sentiment. The inversion of yields at different maturities is generally considered a signal of an economic recession, but whether the economy is actually in recession requires further observation of other economic indicators.

On one hand, the market may be dominated by overly pessimistic sentiment, interpreting the market's expectation of the Federal Reserve's interest rate hike this month, leading to a temporary distortion of the U.S. Treasury yield curve. On the other hand, the trend of the U.S. Treasury yield curve is influenced by various factors. The U.S. bond market is the largest and most liquid bond market globally, dominated by institutional investors. The trend of the yield curve of U.S. Treasuries contains information about price levels, signals from the Federal Reserve on interest rates, bond trading prices, expectations of economic growth, and other interconnected factors. Through different dimensions of interpretation, the market can analyze the trend and expectations of the U.S. macroeconomy. However, in the current complex and dynamic international economic landscape, it is challenging to determine the specific content behind this market signal, and it is difficult to conclude that the U.S. economy will be in a long-term recession. A research report from Bank of America on July 3rd provided a new interpretation of the inversion of the U.S. Treasury yield curve: "Inflation or straight down - U.S. inflation hard landing, economic non-recession - U.S. economic soft landing."

At the same time, it should be noted that if the improvement of other economic indicators offsets the impact of the inversion of the U.S. Treasury yield curve, the U.S. economy may not necessarily go into a recession. In fact, many economic indicators in the United States showed improvement in the first half of the year, offsetting the pessimistic sentiment caused by the inversion of yields in March. The occurrence of two instances of yield curve inversion in history, before the outbreaks of the Asian financial crisis in 1998 and the subprime mortgage crisis in 2007, illustrates this uncertainty. The yield curve of U.S. Treasuries experienced a brief inversion, but it did not trigger an economic recession.

Based on the premise that the inversion of the U.S. Treasury yield curve is not necessarily a signal that the United States is entering an economic recession, the analysis of the impact of the inversion of the U.S. Treasury yield curve on the market should be conducted from multiple perspectives.

Firstly, carefully analyze and judge the duration of the inversion of the U.S. Treasury yield curve in the coming period. According to the above analysis, there is no causal relationship between the inversion of the U.S. Treasury yield curve and an economic recession. Generally, only a long-term inversion of the U.S. Treasury yield curve, forming a trend, is considered a cyclical warning signal of an economic recession. Short-term inversion is often due to incidental factors or black swan events, where the market, driven by the safe-haven effect, sees institutions buying long-term U.S. Treasury bonds. This can result in a situation where the more the yields fall, the more they are bought. However, when the impact of the black swan event fades away, it also means the end of the inversion of the U.S. Treasury yield curve.

Secondly, the term structure of U.S. Treasury yields has a strong negative correlation with the trend of the U.S. dollar index, but the U.S. dollar index is a leading indicator. In theory, the overall level of U.S. Treasury yields and the spread between long and short-term yields are negatively correlated, and the trend of U.S. Treasury yields is positively correlated with the U.S. dollar. Higher U.S. Treasury yields prompt international funds to buy the U.S. dollar, raising the U.S. dollar index. In this process, the U.S. dollar index tends to lead the inversion of the term structure of U.S. Treasury yields in the market, and historical data analysis indicates a time lag of about half a year. Therefore, the earlier strong U.S. dollar has a certain correlation with the current inversion of the U.S. Treasury yield curve.

Thirdly, the term structure of U.S. Treasury yields is positively correlated with the stock market, but the term structure of U.S. Treasury yields is a leading indicator for the stock market. The U.S. dollar index is a leading indicator, and the term structure of U.S. Treasury yields is positively correlated with the U.S. stock market. When the spread between long and short-term U.S. Treasury yields is normal, indicating no inversion, funds flow normally between the bond market and the stock market, and the stock market runs smoothly. When the spread between long and short-term U.S. Treasury yields is abnormal, showing inversion, it generally indicates that the economy is facing problems, and the stock market will shrink accordingly. Through historical data analysis of the U.S. bond market and stock market, the trend of the term structure of U.S. Treasury yields generally leads the U.S. stock market by more than half a year. The impact on the stock market in China requires further analysis in conjunction with the trend of the spread between long and short-term interest rates in the U.S.

In addition, the term structure of U.S. Treasury yields will also have a certain impact on the trends of gold, oil, and other commodities, but this is based on the influence of the U.S. dollar. 

(The original article was published on "21st Century Business Herald" on 5^th July, 2023)