Yield Curve Inversion May Not Predict Recession, But Analyst Says Too Early To Declare 'All Clear' On Downturn

Merrill, a Bank of America company, has thrown a curveball, challenging the traditional wisdom surrounding the predictive power of the U.S. yield curve inversion for recessions.

In Merrill’s latest Capital Market Outlook, penned by Joseph P. Quinlan, managing director and head of CIO market strategy, Merrill Lynch takes a bold stance on the U.S. yield curve and the outlook for 2024.

The inversion of the U.S. yield curve, calculated as the yield differential between a 2-year Treasury note or the fed funds rate and the 10-year Treasury bond, has been in effect since July 2022.

Historically, every U.S. recession since 1970 has been foreshadowed by a yield curve inversion, granting this metric enormous predictive value.

To validate this, the Federal Reserve Bank of New York‘s recession probability model employs the yield curve’s slope, also known as the “term spread,” to estimate the likelihood of a U.S. recession occurring 12 months into the future.

However, in a world where the U.S. economy has defied expectations, weathering sharp Federal Reserve (Fed) rate hikes with surprising resilience, staying calm in the credit markets, and pushing the S&P 500 Index forward, the historical link between an inverted yield curve and impending recessions finds itself under scrutiny, according to Quinlan.

Steeper Yield Curve Benefits Bank Lending Activity

As the analyst argues, researchers have long recognized that the shape of the U.S. yield curve carries valuable insights into the economic outlook.

When short-term yields exceed long-term yields, it has historically provided early warnings of impending recessions, while steep curves have heralded robust early-cycle rebounds in economic activity.

Quinlan goes further to assert that the correlation between the yield curve spread and bank lending appetite five quarters later highlights the link between the curve and subsequent economic activity.

Steeper yield curves, associated with higher term premiums, bolster bank profits and the supply of bank loans, as institutions engage in the critical activity known as maturity transformation, the bedrock of their business.

In stark contrast, a yield curve inversion spells reduced bank lending and, consequently, headwinds for growth.

Currently, the spread between the 10-year Treasury yield, resting at 4.70%, and the 2-year Treasury yield, hovering at above 5%, stands at approximately negative 34 basis points, the lowest level since March 2023, after rising from the lowest value (100 basis points) in over four decades.

US Yield Curve’s Slope: 10-Year Yield Minus 2-Year Yield

The Outlook For 2024

Looking ahead to 2024, Merrill warns of a “significant risk of a potentially meaningful increase in unemployment over the next year.” This caution is grounded in the understanding that it takes approximately a year for a drop in bank lending appetite to manifest as an economic slowdown.

However, the investment bank emphasizes that this uptick in unemployment unfolds within an economy still grappling with labor shortages across multiple sectors, including construction, semiconductors, truck drivers, manufacturing, and others. In other words, the rise in unemployment may fall short of levels seen in the past, offering a silver lining in these uncertain times.

“There are multiple crosscurrents working through the economy, which, is a $26 trillion hydra-headed beast that remains the most competitive and dynamic in the world. Yes, it is too early to declare all clear to the risks of recession,” Merril wrote.

As per equity sector views, Merrill is bullish on the Health Care Select Sector SPDR Fund XLV, while bearish on the Consumer Discretionary Select Sector SPDR Fund XLY. Additionally, the firm favors overweights in the Utilities Select Sector SPDR Fund XLU and the Energy Select Sector SPDR Fund XLE. Conversely, it leans towards underweights in the Real Estate Select Sector SPDR Fund XLRE and the Materials Select Sector SPDR Fund XLB.

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