The US could see a big drop in inflation without hitting a recession, Bank of America said.
Strategists pointed to the inverted Treasury yield curve, the bond market̵[ads1]7;s notorious recession gauge.
But this time the indicator signals a hard landing for inflation, not for the economy.
Inflation could be headed for a big drop and prices could cool significantly without the US having to deal with a recession, according to Bank of America.
Strategists pointed to the inverted 2-year and 10-year Treasury yield curves, the bond market’s notorious recession gauge that has predicted a series of recessions, most recently in 1990, 2001 and 2008. When short-term yields rise above longer-term bonds, it has historically signaled that investors believe that a decline is coming.
The difference between the 2-year and 10-year Treasury yields just steepened to a full percentage point last week, marking the steepest inversion in over 40 years.
This time, however, the indicator reflects more of a hard landing coming for inflation, the bank said, and the US economy is still likely to avoid a sharp downturn.
“While curve inversion hears historical extremes have given models higher recession probabilities, we believe the shape of the curve is more a function of expectations of falling inflation than a weakening in growth,” strategists said in a note Thursday. “A look under the hood suggests that going forward real interest rates are not pricing in elevated recession risk and may instead reflect expectations of a softer landing versus consensus.”
That’s because forward real yields, which represent the market’s expectations of bond yields adjusted for the rate of inflation, have only seen a “modest fall” in the short term, the bank said.
That suggests investors expect the Federal Reserve to pull back interest rates slowly — a move they are unlikely to make if the economy faces a particularly high risk of recession.
“Curve inversion at historically extreme levels does not currently reflect elevated recession risk, but instead is largely related to expectations of cuts alongside inflation converging to target,” strategists added, referring to the Fed’s 2% inflation target.
Investors have been eyeing a potential recession for the past year as the Fed raised interest rates aggressively to tame inflation, a move that threatens to tip the economy into recession.
Prices are now at their highest level since 2007, with Fed officials hinting that more hikes will come later this year. Markets are pricing in an 87% chance that the Fed will raise interest rates another 25 basis points at its July policy meeting, a move that would lift the Fed Funds rate target to 5.25-5.5%.
The New York Fed, meanwhile, has priced in a 71% chance that the economy will tip into recession next year.
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