10-Year Treasury Constant Maturity Minus 2-Year Treasury Constant Maturity
What does it mean?
Recession - We read everywhere that we are heading towards a recession (some may say that we are already in a recession) and some market participants are already incorporating this potential scenario.
The ten (10) year treasury note is a debt or an obligation that a country issues, in this case the U.S. Government, to pay back to the holder(s) the initial amount at maturity plus interests during the life of the note. In simple terms, one gives money to the U.S. Government for them to use it and in exchange the holder(s) receive(s) every six months a percentage on top from that money lent and at the end of the tenth (10) year the U.S. Government gives back the initial borrowed money (let’s call it Nominal or Face Value).
By analogy, one can deduce that the two (2) year treasury note follows the same principle, but the money is lent-borrowed for a shorted period.
If we think about the interest rate that a treasury note should have, we could think on why somebody would decide to give money to the U.S. Government instead of giving it to another Government, to a company or to a friend to start a business. The answer relies in the level of risk. How sure am I that the borrower will return me my money and will also pay the agreed interests?
The probability of not receiving the nominal value and interests is most probably higher when starting a business, considering that starting a business demands a high level of resources and there are no clients yet. In the case of a company, depending on what stage the company is i.e. a mature company it would be less risky than our friend’s new business. What about the U.S. Government? Well, the probability of non-payment is really low when we think that the country would need to have a dramatical shift in their income-expenses behaviour or a “significant imbalance in its budget” plus the printing machine that their Central Bank has would need to stop working. So, there is a probability, indeed, but it is really low.
Right, so we now understand the risk involved in lending the money, but we do not know at what interest rate I should lend my money to the U.S. Government. Here is when the Central Bank plays a role. Because the Central Bank of a country sets the target rate at which banks of a country will lend money to each other overnight with the hope to stimulate or slow down the circulation of money and, and therefore, the dynamics in the economy. The target rate works as a benchmark for other yields in the economy, especially for short-term interest rates, which means that the Central Banks indirectly affects yields on Treasury notes. At this moment the target interest rate is 5.25% - 5.50%.
The next question most probably would be, why would I decide to lend my money to the U.S. Government for 2 years instead of 10 years or the other way around?
One of the main answers to this question is: economic expectations.
Economic expectations play a significant role because you may consider the following when lending your money:
(i) Future inflation: Will the interest that I receive at least cover the inflation for the upcoming period(s)?
(ii) Expected Economic growth: How is the expected economic growth of the country to perform during the upcoming period(s)? Will the economy grow firmly and, thus, I have certainty that I will receive the interest and the face value? Will the Central Bank change the target rate in 10 years to stimulate or slow down the economy?
If today the Central Bank’s target rate is 5.25% - 5.50%, how will it be in two years from now or in ten years from now? Should it be higher, or should it be lower? Most probably one would consider that the longer the maturity then the interest rate would revert to an average where the economy would perform correctly, meanwhile during the shorter period, the Central Bank is more likely to make rapid adjustments to influence economic conditions to comply with its mandate, usually an inflation target in two years time. Some Central Banks like the Federal Reserve includes maximum employment. Also, would you demand a higher interest to be paid if you lend your money for two (2) or ten (10) years? Most probably the longer the period the higher the interest you will demand, since you could use that money for other purposes (this is the so called “opportunity cost”).
Having the above in mind we can now infer that the interest rate of the two (2) year treasury note should be lower than the ten (10) year treasury note, and if we would like to draw this idea we would see something like the following chart:
Euro Area Yield at Different Maturities
The 10-Year Treasury Note minus 2-Year Treasury Note has inverted.
What does it mean?
Simply put, it means that the interest rate (also called yield) of the ten (10) year treasury note is lower than the two (2) year treasury note. i.e. the current rate of the two (2) and ten (10) year treasury notes are 4.026% and 3.848%, respectively. So how do yields currently look in a chart at different maturities ?
U.S. Treasury Yields at Different Maturities
Wait, something is wrong here. This chart means that:
You are wiling to receive less interest lending your money for 10 years instead of lending it for 2 years.
You expect that the Central Bank will have to cut interest rate most probably to stimulate the economy because it will not be performing well.
If third parties borrow money at short-term rates and lend it at long term rates to make profit, this would actually mean that they are dealing with a loss making part of the business.
Regarding the third (3) point, who do that? Banks.
Who play an important role in the circulation of money and, therefore, stimulates or slow down the economy? Banks.
As a Treasury holder you would prefer to lend your money for i.e. 3 months instead of 5 years. On the other hand, the Government will have to pay more interests for shorter maturities, as a consequence the Government would be under more pressure having to pay higher expenses or interests and paying back the face value more often. Furthermore, the latter also applies when the Government has to rollover debt from lower rates to higher debt (which we could think like refinancing debt).
So why is an inversion a warning sign of a recession?
Key points:
Holders of 10-year Treasury notes expect slower economic growth in the future potentially adding a snow ball effect in market sentiment.
Banks may exacerbate the economic slowdown when their profit margins are squeezed.
How long until recession kicks in?
Looking into the near past, from mid-1976, whenever the 10-2 Year Treasury Yield Spread became negative, it took between 1 and 2 years.
Recently in April 2022 the 10-2 Year Treasury Yield Spread became slightly negative and in July 2022 it dug deeper. If history was about to repeat itself, we should expect the recession within mid-2023 and mid-2024.
For the time being, no technical recession but is yet to be seen.
