10y2ys Spread
Anthony
The 10-2 Treasury Yield Spread is the difference between the 10 year treasury rate and the 2 year treasury rate. A 10-2 treasury spread that approaches 0 signifies a "flattening" yield curve. A negative 10-2 yield spread has historically been viewed as a precursor to a recessionary period. A negative 10-2 spread has predicted every recession from 1955 to 2018, but has occurred 6-24 months before the recession occurring, and is thus seen as a far-leading indicator. The 10-2 spread reached a high of 2.91% in 2011, and went as low as -2.41% in 1980.
Typically, we expect long-term interest rates to be higher than short-term rates. By lending at a fixed interest rate for an extended period of time, a lender is exposed to changes in interest rates that effect the market value of the loan or bond - interest rate risk1, or term premium. Plus, the longer the borrower holds the money, the more opportunity there is for something to go wrong - credit risk. Finally, lenders demand a premium for locking up money for an extended period of time - liquidity preference.
The curve is at its widest point during the early stage of the growth cycle, as the central bank lowers short term rates to incentivize lending. Then, the curve compresses throughout the cycle as the central bank raises rates to slow the pace of growth and keep the economy from overheating. When the curve inverts, a recession follows within the next two years. But it is only after the yield curve reverts that a recession is imminent.
The current level of inversion (-0.96% for the 10y2ys and -1.68% for the 10y3ms) is the deepest since the early 1980s. If the Federal Reserve makes good on its plan for two more hikes this year, this inversion may grow even deeper.
In order to maintain the historical pattern witnessed over the past several decades, an inverted yield curve must first revert prior to a recession. A reversion could happen two ways. Either the Fed significantly cuts short-term rates or long-term rates rise significantly (or a combination of the two).
Of course the market may be wrong. If the economy begins to contract and inflation subsides, then rate cuts might happen quicker than expected. Meanwhile, if long-term interest rates spring higher, it would put renewed pressure on the economy and hasten the path towards recession.
If we are waiting on a reversion to indicate an imminent recession, the market suggests there is still some ways left to go. But perhaps this traditional understanding of the yield curve indicator needs to be re-examined.
Understanding the yield curve can provide critical insights into economic cycles. Over the last 40 years, the curve has served as one of the most reliable predictor of recessions. But is this still the case? Let\u2019s explore.
The general business of lending is predicated on this notion, which allows banks or other lenders to \u201Cborrow short and lend long\u201D, capturing the spread between the two rates2. But when short-term rates rise while long-term rates remain fixed, there is less incentive to lend, slowing credit creation and economic activity. Therefore, these interest rate dynamics have strong correlations to the credit and economic cycle.
The U.S. Treasury yield curve, which serves as the benchmark for all other debt securities, is derived from the market yield of Treasury Securities (USTs) ranging in duration from one month to thirty years. The most commonly cited yield curve spreads are calculated by taking the yield of 10-year USTs and subtracting either the 2-year UST yield (\u201C10y2ys\u201D) or the 3-month UST yield (\u201C10y3ms\u201D).
When these spreads are positive, the yield curve is considered \u201Cnormally\u201D shaped and lending is profitable. When these spread are negative, the curve is considered \u201Cinverted\u201D and lending becomes more challenging. As shown below, an inversion of the yield curve has preceded every recession since 1990. Importantly, this inversion is a leading indicator.
Neither of these alternatives seem likely in the near term, at least according to the market. Market expectations of the Fed\u2019s rate path, as measured by Federal Funds futures contracts don\u2019t show an easing of policy rates until early 2024. Meanwhile, the 10-year has trended lower after reaching a recent high point back in October 2022. Assuming the 10-year rate remains constant, a yield curve reversion would not occur until early 2025.
The yield spread indicates the likelihood of a recession or recovery one year forward. The spread equals the difference between the short-term borrowing rate set by the Federal Reserve (the Fed) and the interest rate on the 10-year Treasury Note, determined by bond market activity.
To you stalwart members of the real estate profession, a gift: the ability to forecast the probability of future recessions and rebounds, one year forward. This famed crystal ball is the yield curve spread, also simply called the yield spread.
The yield spread reflects economic conditions as interpreted by bond market investors and Fed economists. To use the yield spread, all the layperson has to do is locate and understand what the current yield spread margin imports.
The second piece of information needed to calculate the yield spread is the interest rate on the 3-month Treasury bill. This interest rate is managed by the Fed as the base price of short-term borrowing, their primary tool for keeping the U.S. economy balanced.
On the flip-side of an economic cycle, a higher or rising yield spread indicates a more vigorous future economy. While good for bond market investors whose actions are full-speed-ahead for profit, a too-high yield spread (and its resulting boom) poses a danger for consumer inflation. When this occurs, the Fed acts to curtail the growth of future jobs and stabilize consumer prices by raising short-term rates.
An over-correction can potentially send the yield spread into low or negative levels. When the yield spread goes negative, or inverts, a recession follows 12 months later. Most recessions are Fed instituted to correct for economic distortions.
That crossover moment gives the real estate broker and agent another signal to adjust their conduct. At the crossover, agents can expect a reduced volume in sales (which will already be slipping), lending and leasing one year forward. Then, in another 12 months, there will be a drop in prices, loan rates and rents, the delay resulting from the sticky price phenomenon brought about by money illusions of sellers and landlords.
The negative spread in late 2006 predicted a 40% chance of a recession to take hold one year forward, around the end of 2007. Then in December 2007, we formally entered the recession. Now we are well into the expansion period of the recovery with employment rising and a low unemployment rate. However, while all jobs lost during the recession have been recovered, not enough jobs have been added to make up for the increase in the working-age population since 2008.
Going into 2020, the likelihood of a decline in general business and real estate activities over the next 12 months was already high as the spread dipped below zero in 2019. However, the added pressure of the global pandemic and financial crash pushed what was to be a normal recession into one of larger significance. The potential devastation was too much for the government to bear, and so an unprecedented level of stimulus was injected into the economy, ultimately pushing inflation to rise rapidly, setting up the economy for the next recession.
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