After first inverting last year, the 3m10y yield curve recently re-inverted, prompting the usual slew of mechanical recession predictions. However, not all inversions are equal. The top-left chart shows that almost all of the YTD decline in 10y yields is from the fall in term premium (TP). In the top-right chart we can see the yield curve in the top panel, and the clear trend break in TP in the bottom panel. Term premium (the residual of short-term rate expectations and the UST yield) has generally been falling since the financial crisis, as central banks acted as large inelastic buyers of sovereign debt. This year, we think the fall in TP has been due to convexity hedging from US mortgage issuers and Asian liability matchers, who have to buy USTs after large moves lower in yields. The bottom-left chart from UBS shows, for instance, the heavy reliance of Taiwanese insurers on US debt to manage their liabilities.
We can strip out the effects of TP on the yield curve by looking at the difference between the 3m rate and a short-tenor forward rate. As the last chart shows, this has as good a track record as the 3m10y curve, but we can also see it has not inverted at all since 2006, and lately has been steepening. As always, when it comes to recession forecasting, we stick to our Recession Signal, which continues to project a low chance of a US recession in the next 3-4 months.
Source: Bloomberg, Macrobond, UBS and Variant Perception