The Yield Curve Could Invert In 2022, Here’s Why That Spooks Markets

One of the best indicators for a U.S. recession is an inverted yield curve. As indicators of U.S. recessions go, it’s among the best, historically speaking. That means the markets watch the shape of the yield curve closely.

What Is An Inverted Yield Curve?

An inverted yield curve occurs when the yield curve has a ‘downward’ slope to it. That means that yields on shorter term bonds exceed those on longer-term bonds. For example if the 2 year yield rises above the 10 year yield on U.S. Treasuries, then most would consider the yield curve inverted. Other factors to consider are how deep the inversion is and how much of the yield curve, the inversion applies to.

The Current State of the Yield Curve

Today, the U.S. yield curve is not inverted, but it’s getting a lot less steep in recent months. There’s a 42bps spread between the 10 year and 2 year U.S. Treasury bond yields today. In March 2021, the spread was triple that. So we could be fairly close to an inverted yield curve, especially because the speed of flattening in 2021 so far has been rapid.

Fed Moves

Part of the driver for a potential inverted yield curve is Fed tightening. The Fed currently expects to life rates in 2022, perhaps by a lot, and the markets agree. A key contributing factor is U.S. inflation running at over 7%. In fact in recent days there’s been some suggestion that the Fed might make a double move up in rates at their March meeting, or, less likely, even deliver an unscheduled move up in rates before the meeting. Then beyond that the markets see further increasing rates in 2022.

Why It Matters

This matters because inverted yield curves have historically predicted recessions and recessions are seldom good for stock markets. Now, the yield curve has not inverted yet, and may not do so because it still has a way to go to get there, but it’s certainly something to watch for 2022.

Of course, the Fed are watching too, and how they react to a potentially inverted yield curve will add further complexity to the picture. The Fed generally aren’t fans of inverted yield curves either, so maybe the prospect of yield curve inversion could temper Fed policy, but with inflation running so hot, the Fed is now in an increasingly tricky position.