Year of the Dog: Will the US Treasury curve invert?

For the third Year of the Dog outlook question, we decided to tackle one of the US financial markets largest predictors: an inversion of the US Treasury yield curve.

Often seen as a harbinger of an economic downturn or outright recession, a Treasury curve inversion gets people nervous. And with US interest rates rising once more, the potential for such an inversion seems higher than in a decade. We asked economists their view as to the likelihood of this taking place: 

Will the US Treasury yield curve invert?

Answer: No

One of the fabled portents of a US economic recession is the inversion of the country’s yield curve. Typically when the two-year Treasury yield is wider than that of 10-year, the end is, if not nigh, then six to 10 months away. 

It’s led the inversion to hold a special reverence among economists. And with the Federal Reserve back into a rate-hiking mode and the US economy growing healthily, many market observers wonder whether this particular harbinger of recession will emerge. 

So far the signs do not look obvious. A certain amount of flattening of the yield curve is possible, even though the difference between two and 10-year Treasuries was only 60 basis points (bp) as of January 31. 

Many economists feel three 25bp rate hikes are in the offing this year, with the first one to come in February. This would be in line with the number witnessed in 2017, and would end with rates at a more normal area than the US has experienced over the past decade. 

The rate hikes will pressure the entire yield curve, although it had already risen as of January 31 over inflation fears. Economists feel the 10-year Treasuries could end the year somewhere between the end of January’s 2.74% yield and 3%. 

It’s possible that as the year spools out the yield of two-year yields will rise slightly more than this rate. They rose above the 2% level for the first time in nearly 10 years on January 12, and could end the year around 2.5% to 2.6%. But an inversion does not appear particularly likely, with the US economy looking set to grow by 2.3% to 2.5% this year and inflation still trending under the Fed’s 2% target.

That said, a yield curve inversion is not beyond the realms of possibility. Were energy prices to begin spiralling upwards, perhaps due to new conflicts among fossil fuel producing nations in the Middle East, inflation could grow faster than assumed, and cause quicker rate hikes. Economists note that it’s also possible the food prices, which are currently low, could surprise on the upside.

As things stand at the beginning of the Year of the Dog, the chances are higher that the US Treasury yield curve will be flat, but marginally inclined. And it’s best to remember that an inversion doesn’t mean a recession is imminent. There is usually a multi-month window before the music stops. 

There may not even be an inversion next year. Few economists predict the US economy will shrink in 2019 (most think the 2.3% growth rate is most likely), despite the fact it will have then been over a decade since it began growing once more—the longest sustained period of growth on record. 

But worrying signs will be accumulating. The US government is spending beyond its means, and its newly passed tax cut will only exacerbate this. That means more borrowing and bond issuance, and higher debt repayment costs. And the government wants to spend yet more money on the military, and has said it will put capital to work in areas like infrastructure too. That could hasten inflation and deteriorate public finances.

The US economy doesn’t have any immediate recessionary fears, but it is building itself bigger problems for the years to come. 

Previous Year of the Dog predictions:

Will Donald Trump still be president at the end of 2018?

What will be the best performing asset class, on a risk-adjusted basis?