Investors in the Treasury bond market are speculating that the Federal Reserve’s interest rate hikes will push the US economy into a recession, despite the recent rally in stocks and decreasing odds of such an outcome. On Wednesday, short-term US government borrowing costs exceeded long-term costs by the widest margin in three months, nearing the 42-year record set during the regional banking crisis in March. This phenomenon, known as an inverted yield curve, which measures the difference between two- and 10-year Treasury yields, has historically preceded every recession in the past five decades.
The yields on Wednesday were 4.74% for the two-year Treasury and 3.78% for the 10-year. Mike Cudzil, a portfolio manager at Pimco, stated that “bad things happen when the yield curve is inverted” and predicts a shallow recession by the end of this year or the beginning of next year. The yield curve first inverted in April last year but has deepened as the Fed has continued to raise interest rates, thereby indicating that markets believe the central bank will persist in tightening monetary policy to control inflation and restrict economic growth.
Federal Reserve Chair Jay Powell’s recent testimony to Congress reinforced the belief that the central bank still needs to combat inflation, despite pausing rate increases at its latest meeting. Higher interest rates have the effect of increasing borrowing costs for companies and individuals while an inverted yield curve can discourage lending by banks, both of which can negatively impact the economy. Jurrien Timmer, director of global macro at Fidelity Investments, opined that “betting against a recession would be foolish” and suggested that a recession typically occurs when the yield curve is significantly inverted for a prolonged period.
Despite the increase in interest rates, economic data has not yet shown a significant slowdown. The addition of jobs by US employers has continued, albeit at a slightly slower rate than in previous years, and unemployment remains low while expectations for economic output have risen. Additionally, the Fed’s own estimates for the economy by the end of the year have improved, indicating a potential avoidance of recession. The US stock market has also rebounded and is now categorized as being in a bull market. Eric Winograd, director of developed market economic research at AllianceBernstein, commented on the market’s resilience and the disparity between market expectations and the view reflected in the Treasury market.
Typically, a yield curve inversion suggests that a recession may occur within the next six months to two years. However, some analysts, including Goldman Sachs, have reduced the likelihood of a recession occurring within the next 12 months to 25%. Riskier assets such as stocks and corporate credit have also experienced optimism, with the S&P 500 share index up approximately 14% this year. However, some analysts argue that the recession concerns may be misplaced. They suggest that the ability of corporations to refinance debt at low rates and push out maturity dates, as well as the prevalence of fixed-rate mortgages for homeowners, may contribute to delaying a wave of defaults and alleviate some of the impact of the yield curve inversion.
The delayed impact on big banks is another factor contributing to the disparity between market expectations and the yield curve inversion. In a typical environment, banks profit from the spread between short-term and long-term yields as they borrow at shorter-term rates and lend at longer-term rates. However, short-term costs have not risen significantly for big banks, as deposit rates at many large institutions remain near-zero. This discrepancy may not prevent a recession, but merely delay it. In the words of Jurrien Timmer, “This is the recession everyone has predicted but refuses to show up so far.”
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