Graphic content – May; the US yield curve is starting to invert

Mike Riddell
Written by

8th May 2018

Many commentators have, probably rightly, started to fret over the shape of the US yield curve. After all, as the San Francisco Fed stated back in March;

‘The term spread — the difference between long-term and short-term interest rates — is a strikingly accurate predictor of future economic activity. Every U.S. recession in the past 60 years was preceded by a negative term spread, that is, an inverted yield curve. Furthermore, a negative term spread was always followed by an economic slowdown and, except for one time, by a recession.’

Indeed, the New York Fed’s recession indicator model is entirely based off the shape of the US yield curve.

It should be alarming, therefore, that on some measures, part of the US yield curve has already started to invert.

The chart below plots the OIS curve, which is a swap curve derived from the overnight interest rate. Over the last month the market has priced that the 1-year Federal Reserve rate will be lower in 3 years’ time than it is in 2 years’ time.

While not yet a sign that the Federal Reserve has gone too far, it is certainly a sign that the market thinks the Fed’s rate ceiling is approaching, and if the trend continues, that the risk of recession is rapidly growing.

Judging by the still very low levels of market implied volatility across all financial markets, and (linked to this) the historically tight levels of corporate bond yield spreads, this is a risk that has not yet been priced into other financial markets outside of the rates market.

The US yield curve is starting to invert
The US yield curve is starting to invert

Source: Bloomberg, 06/11/2017-04/05/2018.

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