Why the bond market is screaming recession, but pricing in something else


The $24 trillion Treasury market, a reliable predictor of past U.S. recessions, has been flashing the same signal for a while: The Federal Reserve’s use of higher interest rates to tame inflation likely will hurt the economy.

Its signal has deepened this year, evidenced by a lopsided Treasury yield curve where investors in 2-year notes now fetch nearly a 5% yield, but those for 10-year paper receive only about 4%.

See: Bond-market recession gauge plunges further into triple digits below zero after reaching four-decade milestone

One read of the situation points to investors bracing for a recession, but also to an economic downturn that would trigger a round of Fed rate cuts to help perk the economy back up.

The problem is, investors don’t yet know where all the chips will fall after a once-in-a-lifetime COVID pandemic, or the ripple effects of the policy response it triggered, including a deluge of fiscal and monetary stimulus to contain its toll.

“We definitely are seeing more resilience in the economy than we were expecting,” said Andrzej Skiba, head of U.S. fixed income at RBC Global Asset Management BlueBay, in a phone interview. “But at the same time, things might not last forever,” he said, warning that the economy could break if the Fed is forced to increase its policy rate to 6%, or beyond, to lower inflation.

“There will come a point when the tightening of financial conditions is such that businesses have to lay off workers, and a good chunk of job openings disappear,” Skiba said.

A close call

Despite the yield curve’s recession warning, financial markets have been signaling the worst of the effects of the Fed’s rapid rate increase may have been included in last year’s carnage.

The S&P 500 index
was up 2.1% on the year through Thursday, while the Nasdaq Composite
was up 8.3%. Of the three big indexes, only the Dow Jones Industrial Average
was lower, down 2.7% year to date.

Perhaps the yield curve’s message, this time, really is false.

In practical terms, the deeply skewed Treasury yields of 2023 only reflect the oddity of investors wanting to earn more for lending to the U.S. government for two years, rather than for a full decade, even through longer-term bets can be riskier.

With inflation higher and stickier than previously anticipated, the Fed needs to be more aggressive, Skiba said. What it can’t do is turn back time, when most U.S. homeowners refinanced at low, 3% fixed mortgage rates, which also blunts the impact of its rate hikes in curtailing consumer spending.

“That is what is giving some chance of a soft landing over the coming quarters, instead of a more traditional expectation of a recession,” Skiba said. “In our opinion, it’s a close call.”

A ‘loaded’ 10-year Treasury debate

Fed Chair Jerome Powell spooked markets Tuesday by suggesting a bigger rate hike could be on the table for late March. The next day he said no decision has been made yet. Stocks ended Wednesday mostly higher, but dropped sharply Thursday.

Dizzying daily market gyrations make it hard to know what kind of economic outcome has been priced into markets.

“The bond market is pricing in a recession, credit spreads are not,” Luke Tilley, chief economist at Wilmington Trust, told MarketWatch. “The stock market is sort of trying to straddle the line in the middle.”

Given the uncertain backdrop for short-term Fed rates, it makes sense that the policy-sensitive 2-year Treasury yield
this week shot above 5%, the highest since 2007.

In late 2007, the Fed began down its path of cutting its policy rate to almost zero as the global financial crisis deepened, a playbook it returned to in 2020 as the pandemic unfolded.

A perhaps tougher job is decoding moves in the equally important 10-year Treasury yield
which this week was knocking on the door of 4%, a level rarely exceeded in the past two decades.

“The 10-year is a loaded question,” said David Petrosinelli, a senior fixed-income trader at InspereX, adding that rates can shift on a dime, and lately have been prone to doing so, even when Powell has repeated the central bank’s overall messaging.

“If the Fed needs to raise rates a little bit more, and hold them there for longer, the knee-jerk reaction is that the economy is strong,” Petrosinelli said. “But if the Fed keeps going, it isn’t going to be strong.”

More mixed messages

Here’s another view on whether the Treasury market is priced for a recession: “No, the market is expecting rates to go back down,” said Robert Tipp, chief investment strategist at PGIM Fixed Income, who sees “upward pressure that keeps the 10-year rate above 4%, rather than below it.”

The direction of the 10-year Treasury rate can hinge on investor sentiment about the economy. The rate matters because lenders use it as a baseline to price almost everything, from consumer loans to corporate debt.

A top worry on Wall Street has been that the U.S. economy might falter when the 10-year rate stays much above 3%, particularly after an era of it running on abundant and cheap debt.

Tipp looked at roughly 140 years of data on the 10-year Treasury rate, which showed relatively few patches in history where it actually held below 3% (see chart).

A sub 3% 10-year Treasury yield isn’t the norm, outside of the past 20 years.

PGIM Fixed Income, FRED, AXIOs Visuals

He still thinks today’s bond-market yields look attractive, and can offset any upward pressure, from here, on interest rates.




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