Fed’s Favorite Yield Curve Indicator Finally Inverts, Recession Imminent

The last four days have seen 10Y yields plunged almost 35bps from their highs while the 3m bill yield has crept higher by around 12bps…

Source: Bloomberg

Which has left the much-watched (and Fed-blessed) indicator of recessions (the 3m10Y Treasury yield spread) has finally gone negative… after watching every other segment of the curve invert…

Source: Bloomberg

Why is this yield curve indicator so important?

Simple – while 2s10s and so on are much discussed, they are quickly shrugged off by the permabull crowd as being overly sensitive – “predicting 10 of the last 5 recessions” for example; in the case of the 3M10Y spread, no lessor venerable institute than The Federal Reserve Bank of New York has blessed this as their preferred recession signal:

“Our preferred combination of Treasury rates proves very successful in predicting the recessions of recent decades.

The monthly average spread between the ten-year constant maturity rate and the three-month secondary market rate on a bond-equivalent basis has turned negative before each recession in the period from January 1968 to July 2006″

Since then it has also been successful at predicting recessions…

The NYFed concludes:

“As for why the yield curve is such a good predictor of recessions, we have reviewed a number of possible reasons, each of which may play an important role at different times. The consistency with which these explanations relate a yield curve flattening to slower real activity provides some assurance that the indicator is valid.“

Crucially, while 2s10s spreads have been popular, they are unlikely to have worried The Fed; but the inversion of the 3M10Y spread is a different matter that may, just possibly, feed the ‘pause’ (or even ‘pivot’) narrative because of its recessionary predictive ability.

Just don’t tell The White House.