Bond Traders Ring Recession Alarm on Imminent Curve Inversion
Bond Traders Ring Recession Alarm on Imminent Curve Inversion
(Bloomberg) -- The world’s biggest bond market is flashing signals that the risk of a U.S. recession is increasing -- even before the Federal Reserve raises interest rates.
The Treasury yield curve has collapsed to near inversion -- a situation when short-term rates exceed those with longer tenors, which has often preceded a downturn. The move has intensified just before the Fed’s all-but-certain rate liftoff next week, with a surge in commodity prices raising the specter of inflation being more persistent than anticipated. Forward markets already show traders preparing for two- and 10-year rates to be inverted in a year.
Bond-market inversions have a long history of being prescient as a harbinger of an economic downturn. With traders currently flexing their muscles, there’s a growing perception of trouble ahead, even if many indicators of economic health -- such as the falling jobless rate -- suggest a recession is still some way off. Russia’s invasion of Ukraine could however prompt a rapid deterioration.
Ed Al-Hussainy, a senior interest-rate strategist at Columbia Threadneedle Investments, noted that an inversion is imminent -- possibly happening as soon as this week.
“We are overdue for an inversion and a resurfacing of all those mothballed conversations that a recession is coming,” said Al-Hussainy. He noted that his firm is positioned to benefit if the Treasury curve keeps flattening, adding that Columbia Threadneedle’s long exposure is in the 10- to 30-year area of the Treasury curve. “Bond investors don’t have to wait around for an actual recession to make money” from flattener bets.
Wagers on parts of the curve flattening are the biggest since 2015, according to Citigroup Inc., which looked at two- and 10-year notes in the futures market.
The flattener has been a very profitable trade as the gap between two- and 10-year cash yields has plunged to around 26 basis points from about 92 basis points at the start of 2022. That puts the spread at a mere sliver of the multiyear high of 162 basis points reached in March 2021, when some Wall Street strategists first called for the end of the steepener trade.
The escalation of the fallout on commodity prices and world markets since Russia’s Feb. 24 invasion of Ukraine has made the Fed’s job harder. There’s even more pressure on officials to tamp down inflation, without significantly denting the economic recovery. Thursday’s reading on the consumer price index is forecast to show the metric climbed an annualized 7.8% pace in February -- even faster than the 7.5% jump in January.
“The speed at which the curve gets to inversion in this environment is also really dependent on the length of this geopolitical crisis,” said Margaret Kerins, head of fixed-income strategy at BMO Capital Markets, which has been predicting the inversion will come after the Fed starts raising rates. The top question Kerins and her colleagues are getting these days is about the curve and its looming inversion, she said.
Historically, recessions come with a year or so lag after an inversion occurs, but there’s risk that the war speeds things along.
The last time the curve inverted was in 2019, after a string of Fed rate hikes. It was the gap between three-month and 10-year yields -- the spread focused on by academic research linking the curve to recessions -- that first went below the zero line in March of 2019, with the two-to-10-year yield gap inverting about five months later. The pandemic-sparked recession hit the U.S. in 2020.
Few economists, however, yet see the U.S. in danger of recession since the economy is underpinned by a strong labor market, solid consumer spending and better-than-expected corporate profits. But many expect growth to slow further if inflation continues to rise.
“Before the ground war began, the curve flattening reflected a notion that the economy has become so conditioned to low interest rates that Fed tightening by the end of the year would slow activity,” said Jack Ablin, chief investment officer at Cresset Capital. “A yield curve inversion has predicted previous recessions, and they were also preceded by high energy prices. The Fed will pay attention to an inversion of the yield curve and it will rattle them.”
It is possible now, however, that the legacy of global quantitative easing could be muddying the message from the bond market. With the trillions in debt purchases distorting prices, some say the curve needs to invert to about negative 1 percentage point to truly give a recession warning now.
The term premium -- which is the added yield cushion investors demand for the risk of holding long-term debt relative to short maturities -- fell in March 2020 to more than negative 1 percentage point, according to the New York Fed “ACM” model. Currently, it’s about negative 0.54 percentage point.
Still, speculation is growing in the bond market that surging inflation, especially the rally in oil and gas prices, will serve to upend the recovery.
“The impact on overall growth from higher energy prices is becoming increasingly more meaningful,” said Tom Porcelli, chief U.S. economist at RBC Capital Markets. “And spending on the basics -- rent, food, and gasoline -- is now chewing up more and more disposable income.”
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