A closely watched measure of the yield curve that is one of the bond market’s most reliable indicators of recession reversed on Tuesday, underscoring fears over the economic outlook as the Federal Reserve plans to aggressively hike interest rates. interest.
The widely followed spread between 2-year TMUBMUSD02Y,
and the 10-year Treasury yields TMUBMUSD10Y,
fell below zero and is down from more than 160 basis points a year ago. The last time the gap reversed was on August 30, 2019, based on Dow Jones Market Data 3-hour levels.
Traders are reacting to the likely need for Fed policymakers to offer an above-normal rate hike of half a point, and possibly more, soon in order to fight inflation. Fed Chairman Jerome Powell opened the door earlier this month to raising benchmark interest rates by more than a quarter of a percentage point at a time, a view backed by d other officials. And signs of progress in peace talks between Russia and Ukraine are allowing the Fed to tighten as needed, some say.
“Bond markets continue to reflect growing pessimism about the outlook for economic growth,” despite a rally in the stock market, said Mark Haefele, chief investment officer at UBS Global Wealth Management.
“The risk of a sharp downturn or recession has increased, along with the prospect of a more rapid sequence of rate hikes from the Federal Reserve and disruption from the war in Ukraine,” he said. he wrote in a note on Tuesday.
Investors pay particular attention to the Treasury yield curve, or the slope of market-based yields across maturities, because of its predictive power. A reversal of the 2s/10s has signaled every recession since the 1950s, according to Principal Global Investors. This is the case with the recession of the early 1980s which followed the inflation-fighting efforts of former Fed Chairman Paul Volcker, the slowdown of the early 2000s marked by the bursting of the dotcom bubble, the September 11 terrorist attacks and various corporate accounting scandals. such as the Great Recession of 2007-2009 triggered by a global financial crisis, and the brief contraction of 2020 fueled by the pandemic.
Already, reversals have occurred elsewhere along the US Treasury curve. The spreads between the 5- and 7-year Treasury yields over the 10-year, as well as the spread between the 20- and 30-year yields, were all below zero.
According to Ben Emons, Managing Director of Global Macro Strategy at Medley Global Advisors in New York.
Ordinarily, the curve does not approach zero until rate hikes are well underway. But he went anyway after only one quarter-point rate hike was below the Fed’s belt.
The chart below, compiled in February, shows how long it took for the 2s/10s to reverse ahead of past recessions compared to this year’s pace. The 2s/10s gap traveled to zero in a matter of months this time around – as opposed to the years it took on its last two trips into negative territory.
Usually, the curve slopes upward when investors are optimistic about the outlook for economic growth and inflation, as buyers of government debt generally demand higher yields in order to lend their money for longer periods.
The reverse is also true when it comes to flattening or inverting the curve: 10- and 30-year yields tend to fall, or rise at a slower rate, relative to shorter maturities when investors anticipate a slowdown in growth. This leads to a reduction in spreads along the curve, which can then lead to spreads falling below zero in what is called an inversion.
An inverted curve can possibly mean a period of low returns for stocks and hit banks’ profit margins as they borrow money at short-term rates, while lending at longer rates.
On Tuesday, the 10-year yield fell below 2.4% earlier in the day as investors priced in a more pessimistic outlook. Meanwhile, the short-term 2-year rate, which is tied to the short-term Fed policy outlook, rose. Meanwhile, the three major DJIA stock indices,
were higher in afternoon trading.