The US bond market is on the move, rapidly shifting from warning of a recession to signaling interest rates are staying higher for longer.
(Bloomberg) — The US bond market is on the move, rapidly shifting from warning of a recession to signaling interest rates are staying higher for longer.
To see the change in sentiment, look no further than the Treasury yield curve — the graph plotting the level of interest rates on federal government bonds maturing anywhere from one month to 30 years.
In normal times, it looks like an upward slope because investors demand higher yields for the risk of having their money tied up for longer.
But before recessions, it flips upside down because slumps are usually accompanied by lower rates. This year, the curve had become more inverted than it had been in decades as fears of a recession mounted.
Now, that’s changing. Yields on longer-dated bonds have been pushing sharply higher, drawing closer to their short-term counterparts.
Such a movement — known as a steepening in industry parlance or even “dis-inversion” — can be a recession signal too.
That’s because, as the economy gets closer to a downturn, short-term yields often drop in anticipation the Federal Reserve will start slashing interest rates to jump-start growth. Traders call that “bull steepening.”
But this time looks different.
Rather than the curve steeping because short rates are falling, it’s changing shape because longer yields are surging. That’s largely because of the US economy’s strength, reflecting the risk that the Fed will hold rates high for some time to come. The process is called a “bear steepening.”
Why Does the Yield Curve Invert?
Segments of the yield curve that have consistently inverted before recessions remain upside down still, albeit far less than they had been.
Such an inversion has usually signaled investors think the economy will stall in the next 12 to 18 months, driving the Fed to cut rates. So the yields on bonds further out on the curve come down to reflect that eventual shift, while shorter ones hold near levels currently set by the central bank.
That can have real world impacts because it squeezes the profit margins of banks, which borrow at short-term rates and lend at long-term ones. By giving them less incentive to lend, it can constrict the flow of credit, slowing the economy. That’s what the Fed wants when it’s tightening policy, as it has been since early 2022.
What Is the Yield Curve Doing?
The recent jump in long yields has been squeezing inversion out of the curve. Even so, parts of it had pushed so deeply upside down that, by historical standards, they’re still ringing alarms. Three-month Treasury yields remain about 80 basis points above 10-year ones. While that’s roughly half what the gap was in late July, it’s still in line with the levels of inversion before the recessions that followed the housing and dot-com bubbles.
Lisa Shalett, the chief investment officer at Morgan Stanley Wealth Management, said in a note to clients that “the cyclical risks to the economy signaled by the yield curve remain.”
When Does the Curve Go Back to Normal?
Usually, the inversion starts to disappear as a recession nears and traders anticipate that the Fed will start cutting rates — and knock down the short-term yields accordingly. A movement like that was seen earlier this year, when fears of a banking crisis flared.
In industry argot, such a move is called a bull steepener because the prices of bonds are rising. In that case, the curve is steepening only because short-term bonds are rallying the most, resulting in those yields sliding back below long-term ones.
What’s Different This Time?
The recent move, instead, is what’s known as a bear steepener. Bond prices are falling, led by longer-dated ones. As a result, their yields are rising more quickly than others.
So the steepening isn’t happening for the usual pre-recession reason. Instead, investors are concluding that policymakers are in no rush to cut rates, given how strong the economy has been. Long-bond yields are pushing up to reflect those expectations. On top of that, the supply of Treasury bonds has surged as the federal government’s deficit keeps growing, likely adding to the downward pressure on prices.
Where Does That Leave Us?
If it looked at first glance like the shift in the yield curve was a solidly positive sign — one indicating that the economy is now at less risk of a recession than it was — that’s probably not the case.
True, it shows traders aren’t expecting the Fed to shift into firefighting mode soon. Even so, it’s almost certain to further dampen the economy as it ripples through to mortgages, credit cards and business loans. That will tighten financial conditions further. That may be a welcome development to the Fed. The risk, though, is that it hits the brakes so hard that the economy stalls completely.
Bond-fund manager Jeffrey Gundlach, the founder of DoubleLine Capital, told the Grant’s Interest Rate Observer conference in New York recently that the market’s moves are a clear “recession warning” and predicted that job losses will start piling up by the end of the year.
In that sense, the forecasting prowess of the inverted curve may be affirmed. Just at a very high cost.
–With assistance from Garfield Reynolds.
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