What to Glean From US Yield Curve ‘Reversion’

In July 2022, the 10-year minus 2-year US Treasury yield curve inverted—short rates topped long. Inverted yield curves (although typically not these maturities—more on that later) are a traditional recession indicator, so this added to elevated economic fears back then. But recession hasn’t come. And, late last month, the inversion reverted—rekindling pundits’ focus and drawing conflicting interpretations. But in our view, this is all making too much of coincidence and too little of causation—repeating the mistake from two years ago.

The debate over reversions’ meaning falls chiefly into two camps. One dubs it a return to normal showing recession risks have faded. This is because 10-year Treasury yields move mostly on inflation expectations while 2-year yields largely reflect fed-funds rate expectations. Whereas rate hikes inverted the yield curve, potential incoming Fed cuts are now (allegedly) poised to restore normalcy. But the other camp says the time to worry is when the yield curve un-inverts—it means recession is at hand. As Exhibit 1 suggests, reversion often occurs just before recession. Supposedly imminent rate cuts must mean the Fed sees trouble brewing, and it is usually slow on the uptake.

Exhibit 1: Yes, the 10 – 2-Year Yield Curve Tends to Un-Invert Ahead of Recessions

Source: Federal Reserve Bank of St. Louis, as of 9/9/2024. 10-year minus 2-year Treasury yields, 6/1/1976 – 9/6/2024.

Problem is, both cases vastly overrate the Fed’s influence. Expectations of Fed actions swing all over the place with no real bearing on what they actually do. See the past year for evidence. And even if rates move, they don’t have any preset economic or market impact. They are just one (usually marginal) factor among many. If rate hikes have yet to tank the economy or bull market, why should cuts automatically help (or hurt)?

The same goes for the 10-year minus 2-year yield curve. While its dips ahead of recessions may seem significant, that is correlation without causation. The yield curve is usually an effective leading economic indicator because it approximates banks’ borrowing short term to fund longer-term loans. So the spread between them helps determine banks’ profits from new lending. But 2-year CDs and borrowings aren’t a big source of funding—so the 2-year yield isn’t a great metric. The 10-year minus 3-month is, in our view, preferable.

Now, the 10-year minus 3-month curve also inverted two years ago, in October. And, as Exhibit 2 shows, banks’ willingness to lend weakened. It was a precursor to 2023’s business lending decline and overall loan growth deceleration. (Exhibit 3) So the effect happened! It just wasn’t strong or widespread enough to drive deep credit contraction, even after factoring inflation in. Why? Banks were awash in deposits. They didn’t need more, so they paid (and largely still pay) deposit rates far lower than 3-month or overnight rates.

Exhibit 2: Inversion and Cooling Supply and Demand for Loans

Source: St. Louis Fed, as of 9/9/2024. Net % of banks reporting stronger Commercial & Industrial loan demand from small and mid/large companies; net % of banks reporting tighter credit standards for C&I loans to small and mid/large companies.

Exhibit 3: Why No Recession? Credit Isn’t Contractionary

Source: FactSet and Federal Reserve Bank of St. Louis, as of 9/9/2024. 10-year minus 3-month Treasury yields and total loans and leases in bank credit, January 1992 – August 2024.

But as Exhibit 2 also shows, the effect of this has already waned: Demand is improving while banks have become more willing to lend. Hence, whether we get reversion or not likely isn’t make-or-break, just as inversion wasn’t.

None of this means the yield curve is a useless relic. It just needs to be properly measured, put into context and monitored for its influence on credit transmission to the economy. We think investors have to weigh “why” something matters, not just “what” has happened historically. Without why, there is little way to assess whether what happened is likely to repeat.