Understanding the US bond market — and what it’s now saying about a recession

We often fret a over the value of the stock mutual funds in our retirement accounts. Recent market volatility is only making matters worse.

Rapid moves in stock prices reflect uncertainty over the state of the economy. The stock market is hard to read; it’s hard to know what’s going on there. The bond market, in contrast, has been a more reliable gauge of what the future holds for our jobs and the cost of living.

Prices in the bond market — the interest rate or yield on bonds — suggest future economic conditions. A framework for understanding this economic forecast is what are called the yield curve and the yield spread. Both of these measures reflect the relationship between short and long-term interest rates.

At this time the yield curve for U.S. Treasury notes and bonds is basically flat. The difference between yields on the two- and 10-year Treasury notes is negative, but just a fraction of a percent. Whether the shape of the yield curve is flat, upward sloping (for higher long-term rates) or downward sloping (lower long-term rates) depends on a number of factors that can be classified into two general categories.

First, investors’ expectations of future interest rates affect the shape of the yield curve. If the curve is downward sloping or flat, as it is today, it is likely that investors believe economic activity will slow and interest rates will be lower in the future. Investors are buying more and more long-term bonds to capture the current rates, holding the yield down on these bonds. The yield on a bond and its price are inversely related.

When the yield curve is upward sloping, or yield spreads are positive, investors must expect future rates to rise. In response to this expectation, investors have sold long-term and bought shorter-term bonds, respectively raising and lowering the yields on each.

Economists have proposed a second theory to explain yield spreads. It may be that investors perceive the risk of holding bonds for longer periods of time to be greater than those of shorter periods. This preference for short-term bonds is called the liquidity premium.

The liquidity premium results from the fact that the longer the time until the principal value of the bond is due to be returned, the higher the probability that principal will not be returned. As the preference for short-term debt becomes greater, investors sell current long-term bonds and buy short-term, again respectively raising and lowering the yields on each.

The former model of expectations appears to best explain the bond market today. Short and long-term yields are slightly negative, which is a forecast of declining economic activity and the lower interest rates that come with such economic downturns.

So regardless of what stock market report you’re reading, the bond market is forecasting a recession. Just try not to fret.

Peter Crabb is a professor of finance and economics at Northwest Nazarene University in Nampa, Idaho. prcrabb@nnu.edu

This story was originally published November 14, 2022 at 10:40 AM.