A closely watched indicator of a coming recession is blaring its loudest warning in over 40 years
- The Treasury yield curve on the 2 and 10 year notes is at its deepest inversion in over 40 years.
- The yield curve is a notorious predictor of a recession, and preceded the downturns of 1990, 2001, and 2008.
The difference between the yield on the 2 and 10-year Treasury notes is the widest its been in about four decades, flashing a notorious warning of a looming recession and a possible sign of more pain to come for stocks, DataTrek said in a note on Monday.
The the 2-year yield has surpassed the yield on the 10-year note for almost a year now, and that inversion has only deepened recently. The 2-year was trading at a yield of 4.241% Monday, compared to a yield of 3.578% on the 10-year.
It's the steepest inversion since the early 1980s, and potential grim omen for the economy, as an inverted yield curve has been a notoriously reliable indicator of a recession in the near-term.
Recession fears have been elevated since the Federal Reserve aggressively tightened policy last year to rein in inflation, raising interest rates by 425-basis-points in 2022. Prices have cooled slightly from highs last summer, but commentators fear that raising rates past their current level could overtighten the economy into a recession.
The central bank is expected to raise interest rates to 5.1%, tacking on another 75-basis-points from current levels. But the 2-year Treasury yield, which is most sensitive to Fed policy, has been on the decline since early November, which could mean the bond market thinks the Fed is bluffing with its promise of more rate hikes, Fundstrat said last month.
"The bond market is discounting Fed policy that is marginally more restrictive than the end of 2022, and many investors will see this as increasing the odds of a 2023 recession. History supports their concern," DataTrek co-founder Nicholas Colas said in a note on Monday. He noted that an inversion in the yield curve that preceded the recessions of 1990, 2001, and 2008.
The inverted 2-10 spread doesn't mean a recession is inevitable, but the economy is now more vulnerable to an exogenous shock, Colas warned, and stocks should brace for some more pain as well.
"It is hard to argue for a strong equity market or valuations when 2s yield [is] this much more than 10s, simply because we know this differential signals an inherent brittleness in the US economy," he added.