The recession gauge for the bond market plunges further into the triple digits below zero after reaching the four-decade milestone
One of the bond market’s most reliable gauges of impending US recessions plunged further into triple-digit negative territory on Wednesday, as Federal Reserve Chairman Jerome Powell reiterated the need for higher interest rates and a possible re-acceleration in the recovery.
The widely watched spread between 2- and 10-year Treasury yields was minus 106.7 basis points in morning trading in New York, after closing at minus 103.7 basis points on Tuesday – a level not seen since Sept. 22, 1981. The spread reached minus 121.4 basis points on that date more than 40 years ago, when the Fed funds rate was 19% under then-Federal Reserve Chairman Paul Volcker.
A negative 2s/10s spread simply means that the policy-sensitive 2-year yield BX:TMUBMUSD02Y is trading well above the benchmark 1[ads1]0-year yield BX:TMUBMUSD10Y as traders and investors factor in higher near-term interest rates and a combination. of lower economic growth, lower inflation and possible interest rate cuts in the longer term.
Powell surprised financial markets during his first day of congressional testimony on Tuesday with more hawkish comments than many expected, sending the policy-sensitive 2-year yield above 5%. As his second day of testimony continued before the House Financial Services Committee, major U.S. stock indexes
DJIA
SPX
COMP
was mixed and the ICE US Dollar Index
DXY
remained close to the year’s highest level.
Meanwhile, Fed funds futures showed traders seeing a 70.5% chance of a half-percentage-point rate hike from the Fed on March 22, up from 31.4% earlier this week, and so a better chance than not. that the fed funds rate will be between 5.5% and 5.75%, or higher, by November, according to the CME FedWatch Tool.
“Every time the Fed becomes more hawkish, the curve becomes more inverted, which is the market’s way of saying that there will be Fed rate cuts later because of a slowdown in growth and/or a recession,” said Tom Graff, chief investment officer for Fasett in Baltimore, which manages more than $1 billion. “It tells you what the market thinks about the sustainability of keeping interest rates this high for a long time, and the market still thinks a recession is quite likely, but not necessarily imminent.”
Tuesday’s triple-digit inversion was largely driven by the rise in the 2-year yield, which ended the New York session above 5% for the first time since June 18, 2007, according to Tradeweb and Dow Jones Market Data.
On Wednesday, the dynamic changed: Most interest rates drifted lower, but the Treasury yield curve still deepened its inversion. That’s because the inversion this time was driven by the 10-year yield falling at a faster pace than the 2-year yield – sending the spread between the two even further into negative territory.
Meanwhile, Powell elaborated on the Fed’s thinking on Wednesday, telling the House committee that policymakers have made no decisions about the March meeting, are not on a “preset path” and still have potentially important data coming up in the next two weeks — including Friday’s U.S. jobs report for February and next week’s consumer and producer price indices.
As Powell’s testimony continued, the 3-month Treasury yield BX:TMUBMUSD03M rose to 4.99%, while the 6-month Treasury yield BX:TMUBMUSD06M rose to 5.26%.
The 2s/10 spread first dipped below zero last April, only to de-invert again for a few months before falling further into negative territory since June and July. It is just one of more than 40 Treasury spreads that were below zero on Tuesday, but is considered one of the few with a reasonably reliable track record of predicting recessions, albeit with a one-year lag on average and at least one. false signal in the past.
By phone, Graff said that “I don’t think the power of yield curve inversion as a signal has changed at all. Every downturn and every cycle is a little different, so how it plays out is a little different. But that signal is just as powerful and accurate as always. I think the economy is going to slow meaningfully in the second half of this year, but not fall into recession until 2024.” Meanwhile, Facet has been overweight healthcare and established technology companies with higher profit margins, lower debt levels and less variability in earnings than in the past, he said.
The Fed chairman’s focus on the need for higher interest rates came as lawmakers repeatedly asked him Tuesday whether interest rates are the only tool available to policymakers to control inflation. Powell responded that interest rates are the most important tool, declining an opportunity to discuss the Fed’s quantitative easing process — or shrinking the central bank’s $8.34 trillion balance sheet — in more detail.
QT was once seen as a supplement to rate hikes, with an economist at the Fed’s Atlanta branch estimating that a passive rollout of $2.2 trillion of nominal Treasuries over three years would be equivalent to a 74 basis point rate hike in turbulent times.
But tinkering with QT now and accelerating the pace of this process would be a “can of worms that the Fed doesn’t really want to open,” said Marios Hadjikyriacos, senior investment analyst at Cyprus-based multi-asset brokerage XM. It would “drain excess liquidity out of the system and tighten financial conditions more quickly, helping to transmit the stance of monetary policy more effectively, but the scars of the ‘taper tantrum’ and repo crisis of 2019 have made Fed officials wary of taking use this tool in an active way.”
See: The secret behind the shares’ success so far in 2023? An unexpected $1 trillion increase in liquidity from central banks.
According to Facet’s Graff, last year’s bond market crisis in England – when a surprisingly large package of tax cuts from the UK government sparked uproar and led to an emergency intervention by the Bank of England – may also play a factor in the Fed’s thinking.
“If the Fed got too aggressive with QT, it could have unpredictable outcomes,” Graff said. “And given that the Fed hasn’t said anything about it, the market has kind of forgotten about quantitative easing as a tool, honestly, right or wrong.”
