August 16, 2022
Our preferred recession predictor has spoken
Yield curve — 10-year U.S. Treasury yield minus 1-year U.S. Treasury yield
The yield curve is essentially the difference between shorter- and longer-term interest rates. As the chart shows, the yield curve has inverted (short-term interest rates moving above longer-term rates) before each of the past eight recessions. We believe yield curve inversion can be an important forecasting tool.
If investors want to select just one yield curve tenor to watch, we favor the gap between the 10-year Treasury yield and the 1-year Treasury yield. Based on our research, when this spread turns negative for at least four weeks or the curve inverts by more than 25 basis points, we view this a strong indication that a recession is likely within the next 12 months (all other factors remaining the same).
What it may mean for investors
Our favored yield curve inverted the week of July 11, more than four weeks ago; as of August 12, it has inverted by more than 40 basis points. We believe this inversion is a strong indicator that a recession is likely within the next 12 months. We favor exposure in U.S. Short Term and Intermediate Term Taxable Fixed Income, as well as municipal bonds. We believe these sectors are positioned to offer investors sustainable yield potential, which we view as a key driver of fixed-income performance.
Each asset class has its own risk and return characteristics. The level of risk associated with a particular investment or asset class generally correlates with the level of return the investment or asset class might achieve. Bonds are subject to market, interest rate, price, credit/default, liquidity, inflation and other risks. Prices tend to be inversely affected by changes in interest rates. High yield (junk) bonds have lower credit ratings and are subject to greater risk of default and greater principal risk. Municipal bonds offer interest payments exempt from federal taxes, and potentially state and local income taxes. Municipal bonds are subject to credit risk and potentially the Alternative Minimum Tax (AMT). Quality varies widely depending on the specific issuer. Municipal securities are also subject to legislative and regulatory risk which is the risk that a change in the tax code could affect the value of taxable or tax-exempt interest income.
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