US inflation rose to 8.3% in the 12 months ended April 2022. VIEW press/Contributor/Getty
The US could see a sharp drop in inflation without slipping into a recession, Bank of America said.
Strategists pointed to the inverted government bond yield curve, the infamous bond market recession indicator.
But this time the indicator is signaling a hard landing for inflation, not the economy.
According to Bank of America, inflation could fall sharply and prices cool significantly without the US struggling with a recession.
Strategists pointed to the inverted yield curve of 2- and 10-year government bonds, the bond market’s notorious indicator of recession, which has successfully predicted numerous downturns, most recently in 1990, 2001 and 2008. When short-term yields rise above longer-term ones, for dated bonds this has historically signaled the investors that a downturn is imminent.
The spread between 2-year and 10-year Treasury yields just steepened a full percentage point last week, the steepest reversal in over 40 years.
This time, however, the indicator reflects more of a hard landing in inflation, the bank said, and the US economy is still likely to avoid a sharp downturn.
“While the curve reversal, reported from historical extremes, has inferred higher recession probabilities from the models, we believe the curve shape is a function of expectations of falling inflation rather than worsening growth,” strategists said in a note on Thursday. “An under-the-hood look suggests that real forward rates are not pricing in heightened recession risk and may instead reflect expectations of a softer landing relative to consensus.”
That’s because real forward yields, which represent the market’s expectations for inflation-adjusted bond yields, have seen only “modest declines” in the short term, the bank said.
That suggests investors are expecting the Federal Reserve to slowly cut interest rates — a move they are unlikely to do when the economy is at particularly high risk of a recession.
The story goes on
“Curve inversion at historically extreme levels does not currently reflect heightened recession risk, but is largely related to expectations of austerity as inflation moves closer to target,” strategists added, citing the Fed’s 2% inflation target.
Investors have had hopes of a possible recession for the past year as the Fed aggressively hiked interest rates to curb inflation, a move that threatens to plunge the economy into recession.
Interest rates are now at their highest since 2007 and Fed officials are pointing to more rate hikes later this year. Markets are pricing in an 87% chance that the Fed will hike rates another 25 basis points at its July policy meeting, which would raise the Fed’s interest rate target to 5.25-5.5%.
The New York Fed, meanwhile, has priced in a 71% chance that the economy will slide into recession next year.
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