Even as stock investors applaud signs of a spike in inflation, the bond market’s best-known recession predictor is showing its clearest signal yet that the US economy is in trouble.
It’s known in Wall Street lingo as an inverted yield curve, and in recent days it’s hit its most extreme levels since the 1982 recession thanks to a sharp drop in long-term bond yields. Where this dynamic has been in place for the past two decades, in each case a recession has followed. (For an overview of the history of yield curves and recessions, see our previous article here.)
Although an inverted US Treasury yield curve is not known to predict the depth or duration of a recession, or even when a recession will begin, market watchers say the current message is unequivocal.
“Historically, when you get a sustained reversal like this…it’s a very reliable indicator of a coming recession,” says Duane McAllister, senior portfolio manager at Baird Advisors.
This leaves many market watchers saying that the real question is not whether there will be a recession, but what it will look like. Will it be superficial or deep? Short or long?
Fund managers and economists wrestle with these questions. Many say the outlook is highly uncertain amid recent economic data which paints a somewhat contradictory picture. On the one hand, inflation has started to come back down from 40-year highs, which should give the Federal Reserve the ability to slow the pace of interest rate hikes.
However, inflation remains extremely high despite its recent easing. At the same time, employment growth and consumer spending remain robust. In fact, the Atlanta Fed’s GDPNow forecast, a common estimate of economic growth, records an extremely high growth rate of 4.2% for the fourth quarter. These indicators suggest the Fed cannot afford to stop raising rates too soon and risks embedding higher inflation into the economy, analysts said.
What is an inversion of the Treasury yield curve?
The U.S. Treasury yield curve is essentially a visual way to represent yields on the range of bonds issued by the U.S. government, from treasury bills to 30-year bonds. The most common way to look at the yield curve is to plot two-year US Treasury yields against 10-year US Treasury bond yields.
Most of the time, yields on longer maturities are higher than those on bonds with shorter maturities, reflecting the higher risks of holding bonds for longer periods.
Under certain circumstances, such as those currently occurring, the shape of the yield curve may invert, with short-term yields exceeding long-term yields. This is called an inverted yield curve.
This year, the combination of hikes in the Federal Funds target rate by the Federal Reserve and expectations of further rate hikes has lifted short-term US Treasury yields above long-term rates. (The federal funds rate is the interest rate for overnight lending between banks.) The Fed has aggressively raised interest rates in an effort to slow the economy to bring inflation back to 40-year highs north of 8% to a target of 2%.
The message of an inverted yield curve is that even though interest rates are high right now, in the future, economic growth will be slower and inflation lower. Historically, this has usually taken a recession to be the case.
How inverted is the yield curve?
Since early July, yields on two-year US Treasuries have exceeded those on 10-years, and over the summer and fall the gap has widened. At the end of October, the two-year US Treasury yielded 4.51%, compared to 0.73% at the end of 2021. Meanwhile, the 10-year US Treasury was at 4.10%, compared to 1, 52% on December 31. .
Jan Nevruzi, US rates strategist at NatWest Markets, explains that one of the main reasons long-term interest rates may have fallen is that investors believe the Fed will be successful in reducing inflation. “Inflation expectations are still pretty entrenched,” he says.
This trend accelerated following October’s Consumer Price Index and Producer Price Index reports, which appear to have confirmed that inflation has peaked and is beginning to decline. This caused bond prices to soar — and yields to fall — with dramatic moves between mid-term and long-term bonds. The yield on the 10-year note fell to 3.67% on November 16, while the yield on the two-year note fell to 4.35%.
The faster decline in yields on long-term bonds than on short-term bonds means that the spread between two-year bonds and 10-year bonds widened to minus 0.68 percentage points. The last time the curve was so inverted was in October 1982, at a time when the US economy was in the midst of a roughly year-long economic downturn.
On another measure of the yield curve, comparing yields on three-month US Treasuries to 10-years, the yield curve is inverted by 65 basis points, the largest inversion for this measure since just before the 2001 recession.
“The market has started to get a bit of disinflationary euphoria,” says Alexandra Wilson-Elizondo, head of multi-asset retail investing at Goldman Sachs Asset Management, adding that she thinks markets are now underestimating the duration of the Fed tightening cycle. continue to.
How bad would a recession be?
Given the warning signs and months of market talk about the potential for a recession – which is generally defined as two consecutive quarters of negative economic growth – if a recession were to occur, there is little reason to surprise investors.
“This will be the most anticipated recession in history,” said John Linehan, portfolio of US large-cap equity income strategy and chief investment officer at T. Rowe Price.
Preston Caldwell, chief U.S. economist at Morningstar, says it’s always a toss-up on whether the economy will officially end up in a recession. But, more importantly, he says, “We’ve always argued that the binary question ‘Will there be a recession?’ misses the point; any recession should be relatively mild and short-lived, in our view.
Baird’s McAllister says a review of the economy’s fundamentals suggests a downturn wouldn’t be too deep. “You have households in pretty good shape,” he says. “People aren’t over-leveraged and even though house values go down, there’s a lot of equity there.” Additionally, corporate balance sheets are healthy and at the state and local government level, overall finances “have never been better, with strong tax revenues…and reserves at record highs,” says -he.
At Goldman Sachs Asset Management, Wilson-Elizondo says the jury is still out on what kind of landing the economy is experiencing following the Fed’s aggressive interest rate hikes. “There are real wild cards that haven’t been resolved,” she says.
One is the impact of the Fed unwinding its massive holdings of bond purchases made during the COVID-19 recession in order to inject money into the financial system and support the economy. (This effort by the Fed is commonly referred to as quantitative tightening.) The second is the pace of China’s economic reopening from its strict “zero-COVID-19” policies, which, depending on the pace and timing, could give a boost to the global economy and also raising commodity inflation.
Within the U.S. economy, Wilson-Elizondo says they focus on three labor market variables to help determine whether there will be a hard or soft landing: the ratio of job openings to job seekers, the participation rate of workers in the labor market and the general pace of job creation.
How much will inflation go down?
As for the inflation outlook, markets have focused in recent weeks on the direction that inflation rates have taken: down. But Wilson-Elizondo says what matters most is where the actual rate of inflation ends up. In October, the CPI posted an annual increase of 7.7%.
“We are very focused on the absolute level more than on the path,” she said. “But in terms of the path, the speed at which (inflation goes down) is very critical.” For now, she said, what seems clear is that it’s hard to see inflation going down to the Fed’s 2% target rate anytime soon, and “we think they’re going to have to stay restrictive”.
At NatWest, Nevruzi says they’re looking for a recession that starts by the end of this year, led by lower consumer spending, “but nothing like a slump where you see activity come to a halt.” . Instead, he says, “we see the economy tipping into a recession, more of a gradual slide, and gradually picking up in 2024.”
Against this backdrop, NatWest expects inflation to gradually decline in 2023, but with CPI remaining above an annual rate of 4% through mid-2023 and only rising to just below 3 % by the end of the year. Some of the slower components such as rental costs or service prices such as air fares will help keep inflation on a “slow track”, he says. “That’s why we think the Fed will rise to 5% (from its current target of 3.75%-4%) and stay at 5% through the end of the year,” he added. he.
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