Market outlook: What the yield curve might be telling us

In my last column, I shared my view that the economy could be on a slow takeoff trajectory rather than a soft landing. That doesn’t mean there won’t be some bumps, but so far, the data behind the fundamentals of the economy continue to show solid and even improving signs of resilience.

When we look at economic conditions, interest rates are very important. There are two categories of interest rates: short-term rates, which are largely set by Federal Reserve (Fed) policy, and long-term rates, which reflect the market’s macroeconomic expectations around growth and inflation. The relationship between short- and long-term rates comprises the yield curve. In 2022 and early 2023, the greatest rise was in short-term interest rates, leading to the unusual situation of short-term rates being higher than long-term rates, which is an “inverted yield curve.”

Speculation about an impending recession has dominated headlines and is certainly still possible. However, many recession probability models put a lot of weight on the yield curve because when short-term rates are higher than long-term rates, a recession becomes more likely. This is often because the Fed has raised short-term rates, which usually dampens long-term economic growth expectations.

What typically happens right before a recession, though, is that short-term rates drop in anticipation of the Fed cutting rates to fight a recession, causing the yield curve to un-invert (short-term rates become lower than long-term rates). Recently, however, there has been a notable increase in longer-term rates, like the 10-year U.S. Treasury bond. The yield curve has become less inverted, but short-term rates have been fairly stable and the market and Fed both expect either only one or even no more rate hikes. This is different and not what would normally precede a recession.

One read of the situation I just outlined is that we may face slow growth and persistent inflation (“stagflation”). However, inflation expectations embedded in markets have not so far increased with the rise in long-term rates. Across the many asset classes we manage, I continue to see underlying economic strength. I am cautiously optimistic for a slow and bumpy but continued takeoff for the economy, barring significant geopolitical turmoil, which is ever-changing and difficult to predict.

If you have questions about the potential impact of the economy and markets on your personal financial strategy, be sure to connect with your financial professional.

David Royal is executive vice president and chief financial & investment officer at Thrivent.