The most credible gauge of the U.S. economic outlook bond market in the last half century has been rushing towards a reversal at a faster pace than in recent decades, and the Federal Reserve has begun to consider aggressively raising interest rates. This raises new concerns about the outlook for the economy.
The widespread spread between the two-year TMUBMUSD02Y, 2.174% and the 10-year Treasury yield TMUBMUSD10Y, 2.384% narrowed to just 13 basis points on Tuesday. From a quarter percentage point at a time. The day was slightly higher as of Tuesday afternoon, but spreads have fallen from 130 basis points last October.
Investors pay close attention to the Treasury yield curve, or the slope of market-based yields beyond maturity, because of their predictive power. The 2s / 10s reversal shows all the recessions of the last half century. This is characterized by the recession in the early 1980s following the fight against inflation by former Federal Reserve Chairman Paul Volcker, the collapse of the dot-com bubble, the 9/11 terrorist attack, and various corporate accounting scandals. It also applies to the recession in the early 2000s. The Great Recession caused by the global financial crisis of 2007-2009 and the short-term contraction of 2020 caused by the Pandemic.
The reversal has already occurred elsewhere along the US Treasury curve, suggesting that the dynamics are expanding and can reach 2/10 seconds soon. The Treasury yield difference between 3, 5, and 7 years and the 10-year yield, and the 20- and 30-year yield differences are all below zero.
Ben Emmons, Managing Director of Global Macro Strategy, said:
At Medley Global Advisor in New York. “But the psychology behind it is just as important. People are starting to think of interest rates that are probably too restrictive for the economy and can lead to a recession.”
The following chart, compiled in February, shows how 2s / 10 has reversed and remained flat this year ahead of the past recession. 2s / 10s flipped briefly in August and September 2019. This was just a few months before the recession caused by the COVID-19 outbreak in February-April of the following year.
Source: Clearnomics, Federal Reserve, Major Global Investors. Data as of February 9, 2022.
Usually, when investors are optimistic about the outlook for economic growth and inflation, the curve tilts upwards because government debt buyers usually demand higher yields to lend money over the long term.
The opposite is true when it comes to flattening or inversion curves. If investors expect growth to cool, 10-year and 30-year yields tend to fall or rise compared to shorter maturities. This can cause the spread to shrink along the curve and the spread, called inversion, to fall below zero.
The reverse curve means a period of low stock returns, where banks borrow cash at short-term interest rates and lend at long-term interest rates, which can hurt banks’ profit margins.
Although slightly steeper on Tuesday, 2s / 10s spreads are flattening at a faster pace than at any time since the 1980s, zero than at similar times during past Fed rate hike campaigns. It is said that it is close to. Emmons, Medley Global Advisor. Normally, the curve will not approach zero until the rate hike goes smoothly, he says.
The Federal Reserve has raised its first rate since 2018 on March 16 and is currently preparing for a 50 basis point move in May. The decision was still being made.
Some market participants are currently taking into account the federal funds rate target, which could eventually exceed 3% from the current level between 0.25% and 0.5%.
Meanwhile, Powell says the yield curve is just one of many things policymakers are paying attention to. He also suggested that the Fed’s spread between interest rates for the first 18 months of the curve (which is currently steep) is a good place to look for a “100%” of the curve’s explanatory power. I quoted the survey.
Source: Bloomberg, Deutsche Bank
However, half a century of performance has been proven with spreads of 2 seconds / 10 seconds. And it’s no exaggeration to say that observers are questioning their predictive power whenever spreads are about to reverse.
read: This is three times the Fed was wrong, denying the yield curve recession warning (April 2019)
“The yield curve is usually a good view for the not too distant future,” said Jim Vogel of FHN Financial. “But nowadays, there are so many things that move at the same time that their accuracy and clarity are starting to decline.”
Vogel said in a phone call that the “terrible” financial market liquidity resulting from the Fed’s exit from quantitative easing and Russia’s invasion of Ukraine was one factor. “People don’t always think. They’re reacting. People don’t know what to do, so for example, if people are generally more thoughtful about their choices, they have a three-year maturity. And those choices usually affect the accuracy of the curve. “
He sees a spread between TMUBMUSD03Y for 3 years, 2.392% and a yield for 10 years, which turned around on Monday as a better predictor than 2s / 10s after Powell’s comment. For a few weeks it will make him believe that the recession is underway.
On Tuesday, government bonds continued to plummet, pushing up yields across the curve. The 10-year rate rose to 2.38% and the 2-year yield rose to 2.16%. Meanwhile, in the afternoon trading, US equities recovered as all three major indices, DJIA, SPX + 0.74%, COMP + 1.13% and + 1.95%, rose.