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By Davide Barbuscia
NEW YORK (Reuters) - A key bond market signal of an upcoming recession has flashed red continuously for the longest time ever, even if the U.S. economy is far from showing signs of a growth contraction.
The part of the Treasury yield curve that plots two-year and 10-year yields has been continuously inverted - meaning that short-term bonds yield more than longer ones - since early July 2022. That exceeds a record 624 day inversion in 1978, Deutsche Bank said in a note on Thursday.
A 2/10 curve inversion is a time-honored signal of an upcoming recession. Short-term bonds yield more than longer maturities because investors expect interest rates to remain high in the short term as the Federal Reserve battles inflation, while long yields are lower on expectations the central bank will cut interest rates to stimulate a weakening economy.
An inverted yield curve is also by itself typically bad for economic activity and financial markets because higher short-term yields lift borrowing costs on consumer and commercial loans, while lower compensation for long-term lending discourages risk-taking.
This time around, however, even if the curve remains deeply inverted after a sharp increase in interest rates, a recession has not materialized and the U.S. economy continues to surprise on the upside. This week the Fed kept its outlook unchanged for three interest rate cuts this year, as it expects inflation to decline despite still strong economic activity.
This is partly because of high consumer savings as the economy exited the Covid-19 pandemic, which provided a buffer against rising borrowing costs, Jim Reid at Deutsche Bank wrote in the note. Also, the Fed managed to contain last year's banking turmoil - which was a result of changes in the shape of the yield curve - by offering emergency liquidity measures.
"So far so good," said Reid.
"However, an inverted yield curve should ultimately be a significant headwind for an economy, as capitalism works best when there is a positive return for taking more risk with lending and investments further out the curve," he said.
(Reporting by Davide Barbuscia; Editing by Toby Chopra)
