While conjecturing on what type of rate hike would be implemented at next week’s July FOMC meeting was “all the rage” last week, concerns of a too aggressive rate increase regime remain front and center. Oh, and by the way, based upon Sunday’s article in the Wall Street Journal, it appears Powell & Co. are leaning toward a 75-basis-point (bp) hike, not the 100-bp move the markets were likely pricing in post-CPI last week. The markets don’t seem to be necessarily debating whether the U.S. economy will enter into a Fed-induced recession but rather just how shallow or deep any downturn may ultimately be.

I’ve written a couple of blog posts this year on the yield curve and its predictability for future recessions. Headlines were certainly “abuzz” on this front last week, as a widely followed measure of the Treasury (UST) yield curve (2s/10s) went inverted yet again. In this latest episode of negative spreads between the UST 2-Year and UST 10-Year yields, the level came out to roughly -20 bps, the widest inversion since late 2000.

Needless to say, this development heightened concerns that a recession is on its way. However, another widely followed gauge, the UST 3mo/10yr yield curve, is still in positive territory. But there is no question that this differential has flattened considerably since I last blogged on this topic in early June. To provide some perspective, as of this writing, the 3mo/10yr spread had narrowed to under +60 bps versus a positive reading of around +175 bps about six weeks ago.

As I’ve mentioned previously, with the Fed’s aggressive use of quantitative easing (QE), one needs to take a deeper look at yield curves before drawing conclusions from the historical past. In my opinion, there is little doubt that Fed purchases of longer-dated Treasuries, combined with safe-haven buying, have played a “distorting” role on the back end of the curve and render a “fresh” look at yield curve analysis.

Perhaps the best way to think about it is that the yield curve may need to reveal a much more noteworthy inversion before signaling a recession could be on the way. For the record, in the case of the UST 3mo/10yr curve, the negative spread reached as wide as -60 bps and -77 bps before the two recessions that came before the most recent COVID-19-related downturn. That being said, as the graph highlights, going back to 1983, a recession did ensue when both of the yield curve measures mentioned here went into inverted territory, which is why recent developments in the UST 3mo/10yr spread caught my attention.

Conclusion

With the Fed poised to raise rates in an unprecedented manner next week (back-to-back 75-bp hikes) and potentially continue the process into the fall months, the odds of an inverted UST 3mo/10yr spread appear to have risen going forward. If the Fed Funds target range reaches a top of 3.50% by year-end (the level currently priced into the futures market), the 3-Month yield should closely follow suit. Simply doing the math, in order to avoid an inverted situation, the 10-Year yield would need to go back to the 3.50% threshold it tested in mid-June, or higher.

If history is any guide on the recession debate, the UST 3mo/10yr curve would seemingly not just move into inverted territory, but the negative reading would come in at a noticeable level as well. Stay tuned; this promises to be a fluid situation.