US yield curve flattening points to tighter Fed policy, not recession: UBS

The spread between 10-year and 2-year Treasury yields now gives a real-time indication of how markets assess Fed tightening against heavy debt issuance, so movements in that gap are poised to become a key signal for rate-sensitive assets. Elevated short-end yields tend to support the US dollar, while equities have held up despite Treasury yields near their highest levels since 2007, leaving them vulnerable if rate hike bets continue to rise. Oil plays a supporting role, as a rebound in crude strengthens the argument for tighter policy, meaning headlines from Iran can quickly shift rate expectations.

The yield curve is flattening as markets anticipate a tighter Fed, and UBS contends this points to tighter policy rather than recession, unless employment, profits and credit conditions begin to deteriorate.

Summary:

• The difference between the 10-year and 2-year Treasury yields has shrunk to less than 30 basis points, with bear flattening picking up pace since the Fed raised rates this month and markets pricing in at least three more quarter-point increases over the next year.
• UBS argues that a flatter or inverted yield curve indicates policy is becoming more restrictive, but does not guarantee a recession. It references Bloomberg data showing the average lead time before a recession since 1978 is about 15 months, ranging from six months to two years, and notes that the 2022 inversions failed to produce the anticipated downturn.
• UBS highlights resilience: the S&P Global US composite PMI for September hit its strongest reading since July 2021 and marked the fourth consecutive monthly acceleration, job data remains solid and earnings are strong, even though University of Michigan consumer sentiment dropped to a four-month low.
• UBS's baseline forecast calls for one more Fed hike in December followed by a pause, and it notes the Fed's own model estimates that 50 basis points of additional tightening would reduce growth by only a few tenths of a percentage point.
• An economist at Aberdeen attributes the rise in yields to real yields, citing weak demand at a seven-year auction and in bill auctions, with the probability of an October rate hike around 70%.
• ISM and payrolls data, additional Treasury auctions and Fed commentary are the upcoming catalysts.

A flattening US yield curve signals that monetary policy is becoming more restrictive, but does not automatically foreshadow recession, according to a UBS note from September 28. The spread between 10-year and 2-year Treasury yields has narrowed to just under 30 basis points, and the key question is whether the 10-year yield will soon fall below the 2-year yield—a condition known as inversion that has historically preceded US economic downturns.

The concept is straightforward. Under normal conditions, investors demand higher compensation for lending over ten years compared with two years, so the yield curve slopes upward and the spread is positive. The 2-year yield is closely linked to where traders expect the Federal Reserve to set rates over the next couple of years, while the 10-year yield also reflects growth, inflation and the supply of government debt. When short-term yields rise faster than long-term yields, the curve flattens—a pattern referred to as bear flattening. UBS says this process has accelerated since the Fed raised rates this month, with markets pricing in at least three more quarter-point increases in the year ahead.

The historical link between inversion and recession is genuine but not precise. UBS, citing Bloomberg data, states that inversions have preceded recessions by an average of about 15 months since 1978, with a range of six months to two years, and notes that the 2022 inversions did not lead to the widely expected downturn. The curve indicates that policy is becoming restrictive, UBS argues, but the ultimate outcome depends on how high the Fed goes and whether economic activity, employment, earnings and credit weaken.

On that front, UBS sees little evidence of strain so far. It highlights the S&P Global US composite PMI for September, which was the strongest since July 2021 and the fourth consecutive monthly acceleration, along with solid jobs data that it expects to keep household income and spending supported, despite a drop in University of Michigan consumer sentiment to a four-month low. UBS also describes corporate earnings as robust. Its baseline scenario is one more Fed hike in December followed by a pause, well below the tightening priced into markets, and it points to the Fed's own model indicating that 50 basis points of additional tightening would shave only a few tenths of a percentage point off growth. In terms of positioning, UBS recommends that investors remain positioned for further equity gains and view rates fixed income as attractive, a view that is the bank's own.

There is a counterargument worth considering. An economist at Aberdeen said this week that the rise in Treasury yields has been driven by real yields rather than inflation expectations, and cited a seven-year auction with the weakest bid-to-cover ratio in a year and softer demand at bill auctions. If investors are reluctant to absorb supply, that can push long-dated yields up and, as one interpretation, make an inversion harder to achieve even as the Fed tightens. The same economist noted that pricing for an October Fed hike has reached around 70%.

Attention now turns to this week's ISM and payrolls data, further Treasury auctions and remarks from Fed officials. A strong labour market would reinforce rate hike expectations and keep the curve flattening, while any signs of weakening in jobs, earnings or credit would turn an inversion into a more significant warning.