(Corrects Allspring Global Investments to Annex Wealth Management in paragraph 13)
By David Randall and Davide Barbuscia
NEW YORK, July 3 (Reuters) - Expectations of another rate hike by the Federal Reserve to tame stubbornly high inflation helped push a closely watched part of the U.S. Treasury yield curve to its deepest inversion since 1981 on Monday, once again putting a spotlight on what many investors consider a time-honored recession signal.
The U.S. central bank has hiked interest rates aggressively over the last year to fight inflation that hit around 40-year highs and remains above its 2% target rate.
The yield curve inverts when shorter-dated Treasuries have higher returns than longer-term ones. It suggests that while investors expect interest rates to rise in the near term, they believe that higher borrowing costs will eventually hurt the economy, forcing the Fed to later ease monetary policy.
The phenomenon is closely watched by investors as it has preceded past recessions.
The yield curve briefly inverted to 42-year lows Monday as investors increasingly expect the Fed to raise its benchmark borrowing rates to keep inflation in check. Rate futures markets reflect a greater than 80% chance of a quarter-point hike later this month but much less conviction the Fed will proceed beyond that, even though Fed officials said in June a second quarter-point increase was likely by year end.
The two-year U.S. Treasury yield, which typically moves in step with interest rate expectations, was down 2.7 basis points at 4.850% Monday. The yield on 10-year Treasury notes was down 3.9 basis points at 3.780%.
Here is a quick primer on what an inverted yield curve means, how it has predicted recession, and what it might be signaling now.
WHAT SHOULD THE CURVE LOOK LIKE?
The yield curve, which plots the return on all Treasury securities, typically slopes upward as the payout increases with the duration. Yields move inversely to prices.
A steepening curve typically signals expectations for stronger economic activity, higher inflation and higher interest rates. A flattening curve can mean investors expect near-term rate hikes and are pessimistic about economic growth.
HOW DOES THE CURVE LOOK NOW?
Investors watch parts of the yield curve as recession indicators, primarily the spread between three-month Treasury bills and 10-year notes, and the two- to 10-year (2/10) segment.
Yields on two-year Treasuries have been above those of 10-year Treasuries since last July.
That inversion briefly reached negative 109.50 basis points on Monday as shorter term yields fell less than longer-dated ones, creating the largest gap between shorter-dated and longer-term yields since 1981. At that time, the economy was in the early months of a recession that would last until November 1982, becoming what was then the worst economic decline since the Great Depression.
"It's not unusual to get a yield curve inversion but it is unusual to get one of this magnitude. We haven't seen one like this in quite a while," said Brian Jacobsen, chief economist at Annex Wealth Management.
Concerns about the lagging economic impacts of the Fed's aggressive path of rate hikes has kept the yield curve inverted for more than a year. Yet the recent push that has deepened the inversion may be a result of leveraged positions by hedge funds and other institutional investors as issuance by the Treasury Department surged since the passage in early June of a Congressional plan to raise the debt ceiling, analysts say.
Deeper inversions do not necessarily mean deeper or longer recessions, Jacobsen said.
The curve plotting yields of three-month bills against those of 10-year notes, which had already inverted in intraday trading in July, turned negative in late October, closing inverted for the first time since early 2020.
WHAT DOES AN INVERTED CURVE MEAN?
The inversions suggest that while investors expect higher short-term rates, they may be growing nervous about the Fed's ability to control inflation without significantly hurting growth. The Fed has raised rates by 500 basis points since it started the cycle in March 2022.
The 2/10 year yield curve has inverted six to 24 months before each recession since 1955, a 2018 report by researchers at the San Francisco Fed showed. It offered a false signal just once in that time. That research focused on the part of the curve between one- and 10-year yields.
Anu Gaggar, global investment strategist for Commonwealth Financial Network, found the 2/10 spread has inverted 28 times since 1900. In 22 of these instances, a recession followed, she said in June.
For the last six recessions, a recession on average began six to 36 months after the curve inverted, she said.
Before this year, the last time the 2/10 part of the curve inverted was in 2019. The following year, the United States entered a recession caused by the pandemic.
WHAT DOES THIS MEAN FOR THE REAL WORLD?
When short-term rates increase, U.S. banks raise benchmark rates for a wide range of consumer and commercial loans, including small business loans and credit cards, making borrowing more costly for consumers. Mortgage rates also rise.
When the yield curve steepens, banks can borrow at lower rates and lend at higher rates. When the curve is flatter their margins are squeezed, which may deter lending.
(Reporting by Davide Barbuscia and David Randall; editing by Megan Davies, Tomasz Janowski and Richard Chang)