With the Federal Reserve on course to raise its target interest rate again in December, there’s concern that overly aggressive monetary policy could endanger the current US economic expansion, one of the longest in history, albeit not the most robust one so far. One of the leading indicators we look at to gauge the potential for recession is the US Treasury 10-2 year yield spread, pictured above. It shows the difference between the yield on 10-year Treasuries vs. 2-year Treasuries, and measures the additional compensation an investor would earn for holding longer maturity bonds. Now take a look at the gray vertical bars, which indicate US recessions. Notice that prior to the start of recessions, the blue line dipped below zero. That is when the yield on 2-year Treasury bonds was actually higher than the yield on 10-year Treasury bonds. Below zero is an unusual situation because it suggests investors have a weak economic outlook and believe long-term yields are likely to fall.

So where are we now?

Well, this measure suggests the economy has further room to run. As you can see, the “yield spread” is still positive, aka normal: 10-Year Treasuries are yielding more than 2-year Treasuries, although that gap has been shrinking. Also, note that historically, even after the spread turns negative, roughly a year or more passes before the recession occurs. So as with all market indicators, this measure isn’t a precision instrument.

We think the yield spread will continue to narrow. Demand for yield and relatively muted inflation will keep long-term yields from rising despite Fed target rate hikes pushing shorter-term yields higher. Additionally, the proposed US tax reform has some things in it that could drive up shorter-term yields relative to long-term ones:

(1) The extra deficit caused by tax cuts is expected to be funded with short-term Treasury debt, causing shorter-term yields to rise due to the extra supply;

(2) The interest that corporations pay to their bondholders might no longer be deductible, leading to less issuance of longer-term corporate bonds and preventing yields from rising as much on longer-term debt due to less supply.

As we monitor the financial markets and the economy, the 10-year to 2-year yield spread will be a valuable indicator for our predictive toolkit.