One of the Treasury market’s most reliable gauges of impending U.S. recessions has the potential to shrink to its narrowest level in 41 years within a matter of months, according to BMO Capital Markets strategists.
That indicator is the spread between 2- TMUBMUSD02Y, 4.447% and 10-year Treasurys TMUBMUSD10Y, 4.010%, which becomes inverted whenever the shorter-term rate trades above the longer-term one. The spread hovered around minus 45 basis points as of Tuesday, and has been below zero since July, when Federal Reserve policy makers made it clear that elevated inflation could become entrenched.
The 2s10s spread now has the potential to reach minus 75 to minus 100 basis points either after Jan. 1 or during the period between November’s U.S. midterm elections and the Federal Open Market Committee’s Dec. 13-14 meeting, said BMO rates strategists Ben Jeffery and Ian Lyngen. BMO’s view comes a day after a Bloomberg Economics forecast model pointed to a 100% probability of a U.S. recession within the next 12 months.
“Admittedly, the highest conviction on our year-end calls are in terms of levels,” Jeffery and Lyngen wrote in a note on Tuesday. The 2s/10s spread “reaching the -75 bp to -100 bp zone could certainly take place on the other side of the New Year as easily as it could in the run up to holiday trading conditions coming out of the midterm elections and around the December FOMC.”
“In terms of the driver of such a repricing, we are watching for Treasuries’ status as the benchmark safe haven asset with the backdrop of a global economy that no longer benefits from an accommodative policy to be the bullish driver toward lower rates,” they said.
The last time the 2s10s spread ended the New York session in triple-digit negative territory was Sept. 22, 1981, when it was minus 121.4 basis points, according to 3 p.m. figures from Dow Jones Market Data. At that time, Ronald Reagan was in his first year as president, the annual headline inflation rate was above 10%, and the U.S. economy was in the early stages of what would turn out to be one of the worst downturns since the Great Depression, triggered by the Fed’s tight monetary policy under Paul Volcker.
Though a negative Treasury curve doesn’t translate immediately into a recession, it has a track record of translating into one at some point: This was the case with the early 2000s downturn marked by the bursting of the dot-com bubble, the 9/11 terrorist attacks, and various corporate-accounting scandals; the 2007-2009 recession triggered by a global financial crisis; and the brief 2020 contraction fueled by the Covid-19 pandemic.
Even with the 2s10s spread stuck below zero for months, though, investors have been willing to dismiss a whole lot of negativity, whether it’s cracks in global financial markets, a hotter-than-expected consumer-price index for September, or the risks of continued high inflation. What’s more, a recent crisis of confidence in the U.K.’s bond market has only emboldened investors’ perception that policy makers would likely ride to the rescue, if needed.
On Tuesday, all three major indexes DJIA SPX COMP finished higher as investors digested the latest round of corporate earnings reports. Meanwhile, Treasury yields held steady as calm prevailed in bond markets following the U.K. government’s budget U-turn this week.