7 mins read . 03 Aug 2022
Between April and July 2022, the US Yield Curve flashed a recession signal thrice. What exactly is a recession signal? When the Yield curve inverts, it usually signals an upcoming recession. The yield curve is a chart that shows the relationship between tenure and bond yields. Typically, the longer the tenure, the higher the yield because bond buyers expect to be compensated for higher risk. That is why the yield curve has a positive slope.
Why does the yield curve invert? It happens when investors prefer short-term bonds over long-term bonds due to uncertainty and expectations of a slowdown in the economy. That is what has happened in the US. Even as the yield curve has turned negative, the GDP growth in the US has dipped into negative for two quarters in succession (March 2022 quarter and June 2022 quarter). The chart below captures this trend.
How do we identify a recession? One standard definition is two consecutive quarters of real GDP contraction. March 2022 quarter saw -1.6% GDP contraction, and June 2022 was -0.9%. However, the June GDP estimates are part of GDPNow by the Atlanta Fed, and the official figure is yet to come from the US government. There are indications that the US may be dipping into recession, which one can largely attribute to the ultra-hawkish stance adopted by the Fed, which hiked rates by 225 basis points between March and July 2022.
One of the reasons that the fear of recession has become prominent in the last few months is the hawkishness of the Fed. It has hiked rates by 225 basis points and is poised to raise rates by another 100-125 basis points in the current calendar year. The whole problem is that the US Fed has already reached a rate of 2.25-2.50%, generally referred to as the neutral rate. Till this point, the impact on growth is limited.
Once the neutral rate of 2.50% is crossed, every 10 bps rate hike can deeply affect GDP growth. Effectively, the US has a combined hawkish Fed, neutral rates and real GDP growth starting to falter. One argument is that real GDP is negative in the US due to steep inflation. Once inflation comes under control, real GDP will automatically turn positive. However, US inflation rose and stood at a 41-year high of 9.6% in June 2022.
Between April and July 2022, the yield curve inverted thrice. What exactly do we mean when we say that the yield curve has inverted? The yield curve inversion is measured as the yield spread between 10-year yields and 2-year yields. Ideally, you should earn more on a 10-year bond than on a 2-year bond since tenure risk is higher. However, under expectations of recession, the future becomes highly uncertain. Investors prefer 2-year bonds over 10-year bonds, and the higher demand raises the yield. This negative spread is the inverting of the yield curve.
The million-dollar question is whether yield curve inversion is a reliable indicator. In the last 60 years, the yield curve has inverted between 6 months and 24 months in advance before each recession. Since the start of the 20th century, the (2/10) yield curve spread has predicted recessions correctly on 22 out of 28 occasions. That is a relatively reliable indicator.
India would not be immune to a US recession. Here is why.
While the US Fed has downplayed the risk of recession, it would eventually depend on how quickly the US inflation comes down. India will be watching that closely.
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