Government Bond-Market Measure Says Recession Risk Growing

Yield on short-term Treasurys has been higher than on long-term notes for more than 30 consecutive trading sessions

by Daniel Kruger
Wall Street Journal
July 9, 2019

yields on treasurysThe yield on short-term Treasurys has been higher than on long-term notes for more than 30 consecutive trading sessions, a sign that investors are concerned about the durability of the decade-long economic expansion.

The yield on three-month bills has exceeded that of the benchmark 10-year Treasury note by as much as 0.259 percentage point, the most since May 2007, before the financial crisis. Shorter-term bill yields tend to reflect expectations for Federal Reserve interest-rate policy, while those on longer-term securities move largely with expectations for growth and inflation.

Investors watch the dispersion between yields on short- and longer-term Treasurys, known as the yield curve, because shorter-term yields tend to exceed longer-term ones before recessions. Investors call that a phenomenon an inverted yield curve.

Two different financial models used by the Federal Reserve Banks of New York and Cleveland each show that the probability of a recession in the next 12 months has risen to about 1 in 3, odds last reached in 2007.

The likelihood has increased as the yield on the 10-year Treasury note, which decreases when bond prices rise, has fallen to multiyear lows. The decline has been fueled in part by expectations that the Federal Reserve could reduce its target range for its overnight interest rate more than once this year.

Investors remain divided about whether an inverted yield curve is signaling a downturn is coming. One reason is recent upbeat data, such as Friday’s jobs report for June, which showed the U.S. added more jobs than economists had forecast. Another is that the Fed has indicated possible rate cuts, which could lower borrowing costs for consumers and businesses, potentially stimulating more growth and investment.

“It’s hard to ignore the inversion and the signal the market is sending,” said Sean Simko, head of fixed-income portfolio management at SEI Investments. Yet there is a chance that timely Fed rate cuts could sustain the expansion. “The end result isn’t written in stone yet,” he said.

Mr. Simko said he could buy more 10-year Treasurys if yields rise, but he expects them to end the year lower than they are now.

The yield on 10-year Treasurys—which serve as a key reference rate for everything from home mortgages to business loans to bonds that fund municipal infrastructure—settled at 2.058% Tuesday, down from its recent high of 3.232% in November. The three-month bill yield was 2.249%.

Most investors and Fed officials agree that economic growth is decelerating from last year’s 2.9% pace. Economists say effects of changes in monetary policy operate with a lag, making it unclear how much or how quickly lower rates would affect slower growth.

And inversions in the yield curve have typically happened six to 24 months before a downturn, making it unclear how to gauge their signal.

Some analysts argue that rate cuts can do little to stimulate growth that the decline in bond yields isn’t already doing. For example, the pace of new home building has decreased since last May, according to Commerce Department data. Housing starts have declined even as average rates on 30-year fixed-rate mortgages have fallen to 3.75% from 4.52% a year ago, according to Freddie Mac.

“They’re probably not going to be able to cut in a way that prevents” a recession, said Lisa Shalett, chief investment officer at Morgan Stanley Wealth Management. One reason is that the Fed has little influence on rising trade tensions and tariffs, which many investors and analysts say have led to a slowdown in global growth.

“Lower interest rates don’t create more certainty about trade,” Ms. Shalett said.