The U.S. Treasury yield curve briefly inverts. Should markets be concerned?
On the latest edition of Market Week in Review, Director of Investment Strategies, Shailesh Kshatriya, and Director of Institutional Investment Solutions, Greg Coffey, discussed market reaction to the latest developments in the Russia-Ukraine war. They also assessed potential signals from the recent inversion of a key segment of the U.S. Treasury yield curve, and reviewed March PMI (purchasing managers’ index) numbers from China.
Unpacking the market reaction to Russia-Ukraine peace talks
The week of 28 March kicked off with increasing investor optimism over the status of peace talks between Russia and Ukraine, which have been locked in a month-long war that began when Russia invaded Ukraine in late February, Kshatriya noted. Hopes for an end to the conflict were centred around a framework for de-escalation that could have involved Ukraine being more open to discussions relating to territorial disputes over Crimea and the Donbas region, he explained. In addition, the framework also called for Ukraine to potentially renounce its bid to join NATO (the North Atlantic Treaty Organisation) in exchange for security guarantees from Western nations, Kshatriya stated.
Amid the peace talks, he said that Russia offered to reduce its military presence around some Ukrainian cities, including the capital of Kyiv. “Russian negotiators had indicated these moves were proposed to build trust and create conditions for further negotiations, including an eventual meeting between President Vladimir Putin of Russia and President Volodymyr Zelensky of Ukraine,” Kshatriya noted. However, contrary to what the negotiators had indicated, most Russian troops stationed near the capital did not move away from Kyiv, he said. In addition, both Ukraine and Russia expressed disagreement over how much progress was actually made at the 29 March peace talks, he added.
“Ultimately, as has been the case many times since the war in Ukraine began, a brief period of hope was dashed by the realities occurring on the ground,” Kshatriya observed, noting that investor optimism for a de-escalation in the conflict had largely faded by 31 March. While markets have continued to ebb and flow over the past few weeks on the perceived direction of peace talks, a quick resolution appears doubtful, he said.
What are the implications of an inverted U.S. Treasury yield curve?
Turning to bond markets, Kshatriya noted that a key segment of the U.S. Treasury yield curve briefly inverted on 29 March. This caught the attention of investors, he said, because a yield-curve inversion is traditionally seen as a potential recessionary signal.
Under normal circumstances, the yield curve - which plots the yields of debt instruments against their time to maturity - is upward-sloping, meaning that yields on longer-dated bonds are higher than yields on shorter-dated bonds, Kshatriya explained. “When longer-dated bonds yield less than shorter-dated bonds, the curve becomes inverted - and this is a worrying sign because, historically, a yield-curve inversion precedes a recession, he stated.
The length of time between when the yield curve inverts and a recession begins often varies, Kshatriya said, with the historical average somewhere between 12 to 18 months, depending on the portion of the curve that inverts. He added that the two most-watched segments of the curve are the spread between 10-year and 2-year Treasury yields, and the spread between 10-year and 3-month Treasury yields.
“On 29 March, the spread between the 10-year and the 2-year briefly inverted. As of 31 March, that portion of the curve is no longer inverted, although the spread between the two Treasury notes is still exceptionally narrow - at only a few basis points as of this recording,” Kshatriya stated. The small gap between the two suggests a slowing macroeconomic outlook, he said.
Conversely, the spread between yields on the 10-year and 3-month notes is still quite steep, at around 180 basis points, Kshatriya noted, which indicates that current financial conditions are still accommodative. “The steepness of this part of the curve is due mainly to the 3-month yield closely tracking the federal funds target rate of 0.25% to 0.50%, which is still relatively low,” he explained. However, with the U.S. Federal Reserve (Fed) now in an undeniably hawkish mode as it seeks to tame red-hot inflation, Kshatriya said the 10-year/3-month spread should also start to narrow as the U.S. central bank continues lifting rates.
“At Russell Investments, we take all signals from the U.S. yield curve seriously. In this case, while the brief inversion on March 29 was noteworthy, we believe the magnitude and persistence of a yield-curve inversion are of greater importance - and much of this will ultimately depend on the extent and pace of Fed rate hikes,” he stated.
China PMI readings decline. Are recent COVID-19 lockdowns to blame?
Switching to China, Kshatriya said the latest PMI data indicates that both the country’s manufacturing and services sectors are contracting. In March, China’s official manufacturing PMI declined to a level of 49.5 - down from a reading of 50.2 in February - while its non-manufacturing PMI fell to 48.4, versus a reading of 51.6 in February. A number above 50 indicates expansionary conditions, while a number below 50 indicates contractionary conditions, he explained.
The current readings are China’s lowest since early 2020, Kshatriya said, and appear to be a result of recently imposed COVID-19 lockdowns amid a surge in infections. “Chinese businesses are indicating that these lockdowns are disrupting production and contributing to labour issues,” he remarked. Complicating matters further, Shanghai - the largest city in China and an important financial hub - entered a two-phase lockdown the week of 28 March, suggesting that April PMI surveys could also come in on the soft side, Kshatriya noted.
Ultimately, the country’s weakening growth outlook means that the government will need to announce more definitive policy measures to support the economy, in order for China to achieve its previously reported target growth rate of 5.5% for the year, he concluded. “Without a doubt, this will be an important watchpoint for markets moving forward,” Kshatriya remarked.