ETFs to Watch as Yield Curve Narrows

Are we going to have a recession this year? Heck if I know. No one does. 

That’s not stopped investors and Wall Street analysts obsessing, as if someone had asked “are we in a bull market or a bear market?” Maybe you know the old joke for situations like this: ask 5 people, get 9 answers.  

Instead, how about looking at a recession indicator that has led to each recession over the past 70 years? The spread between the ten-year and two-year US Treasury securities has “inverted” between six and 24 months before every recession since 1955, according to a 2018 San Francisco Fed study. That is, the yield on the two-year bond was higher than the yield on the ten-year bond.  

That’s not normal when we consider that a “rational” investor would normally demand a higher rate for lending their money for a longer period. Inversions represent that there is some reason that things are out of whack. 

Yield Curve and Recession Forecast Not What You Think 

However, the part that is often overlooked because it’s essentially an afterthought of this yield curve issue, is that an inverted yield curve is not what signals a coming recession. It is the un-inversion, or the reversal of that inversion. That is, when the ten-year bond again yields more than the two-year security.  

That part hasn’t happened yet. But that signal is getting closer to firing.  

The bottom line is that investors and investment advisors should pay close attention to it. Because in a modern market environment where emotions play such a big role in influencing market narratives and prices, if we soon see the yield curve revert to normal, it could be anything but a normal reaction market reaction. 

That’s because recession fears have calmed down considerably in recent months, and there is more talk about the Fed declaring victory against inflation and recession than guarding against future trouble.

Jerome Powell and the Yield Curve Spread

Fed Chairman Jerome Powell was interviewed on “60 Minutes” Sunday night and while he did his typical word salad dialogue, the segment finished with him talking about Fed credibility and that being all people ultimately have. That might make some folks think twice about assuming that traditional recession signals like the yield curve spread are no longer useful. 

Here's the data to note as of last Friday: the ten-two yield curve spread was -0.33%. That dropped down from a recent high point of just 0.19% below a return to normalcy for the yield curve. It is also up from -1.06% last June, so it has closed most of the gap.  

The wildcard here, like so many things in today’s markets, is the pandemic. Specifically, the way that the post-pandemic era has messed up a lot of traditional market indicators.  

ETFs to Watch as the Yield Curve Narrows 

That, in turn, has allowed ETFs like the iShares 1-3 Year Treasury Bond ETF (SHY) to deliver a rare 3% return the past six months, something it has only done once since 2009, and that was during the pandemic panic of early 2020. SHY does not invest only in two-year Treasuries, but essentially surrounds it with that 12-36 month holding range for its portfolio. 

Contrast that with the iShares 7-10 Year Treasury ETF (IEF) which is similar in performance to that of a ten-year bond, which gained only 2.5% in the past six months, less than a year after it posted a 7% return in a period of the same length. These are all signs that the Treasury curve inversion era is getting mature (pardon the bond market pun), and that something is likely to happen soon.  

The shorter end of the bond curve could dip while the longer end stays around where it is or falls less. Or they could both rise in yield but the longer bonds spike higher by more basis points. Either way, that once historically high spread between tens and twos has come back together. When it will go all the way is anyone’s guess, but it is likely to create a ton of a buzz in the ETF industry when it does.