Economy

Fed’s Yield-Curve Barometer Starts Flashing Recession Risk By Bloomberg



(Bloomberg) — A classic recession warning is flashing in the US Treasury market, where the 10-year note’s yield fell below the three-month bill’s, a rare occurrence that signals investors anticipate dire economic consequences of the Federal Reserve’s campaign against inflation.  

After brief inversions Tuesday and early August, the 10-year fell as low as 0.08 percentage points below the three-month in US trades Wednesday. The day’s lows for both yields were reached shortly after the Bank of Canada raised its policy rate by half a percentage point, less than expected.   

This segment of the Treasury curve inversions are common during Fed tightening cycles. Three-month bills track Fed’s policy rate, while longer-term borrowing costs reflect inflation expectations and economic growth. While other segments of the Treasury curve that are closely watched by the Fed, such as the five- to 30-year and two- to 10-year yield curves, have been deeply inverted for most of this year’s time, the Fed monitors this one more closely.

“We are certainly in territory with the Fed’s official barometer of the yield curve that will raise concerns,” said Gregory Faranello, head of US rates trading and strategy at AmeriVet Securities. “The Fed will definitely watch this, and there is a sense in the bond market that they will soon throttle back the pace of rate hikes and take a step back.”

Another three-quarter-point hike from the current 3% to 3.25% range is still expected for next week’s policy meeting, based on swap contracts referencing the event, but traders are divided on whether the subsequent move will be 50 or 75 basis points in December.

As the US central bank tries to use rate increases to bring down inflation, the risk is that economic activity responds more quickly, and that the Fed won’t lower rates until there’s progress on inflation.

After gauges of consumer confidence and home prices falling more than expected, long-dated Treasuries surged sharply Tuesday. Last week, the US 30-year fixed mortgage rate topped 7% for the first time since two decades. This is an example of how Fed rates increases are flowing through the economy.

Inversions in the 3-month-to-10-year yield curve have been a sign of past recessions. The curve was as low as 0.28 percent in March 2020 and went into deep negative in 2019, 2007, and 2000 at the close of Fed tightening cycles.

The prospect of Fed hikes continues to exert upward pressure on bill yields. However, the 10-year has fallen from multi-year highs. It reached a peak of 4.34% last week after rising from 1.5% in January. As economic weakness increases, buying now could prove to be a good investment. Rate cuts may occur by 2023 or 2024.

“It will be difficult for the Fed not to overtighten as inflation will lag the economy and they are so focused on slaying the inflation dragon,” said Donald Ellenberger, senior portfolio manager at Federated Hermes (NYSE:). “It’s a time for sticking with quality bonds and we have no problem extending duration in Treasuries.”

This week’s positioning surveys revealed that investors have been increasing interest-rate risk to their portfolios in order to reap the benefits of falling long-term yields. The SMRA portfolio survey was net long for the first time since 2021, while JPMorgan Chase & Co (NYSE:).’s Treasury client survey was most bullish in two years.

“Our duration was shorter than the index for most of the year and we began getting closer to neutral a month ago when the 10-year was around 3.55%,” said Ellenberger. “We were a little early and we do think the bulk of the upward adjustment in yields is behind us.”

(Adds context to sixth paragraph.

©2022 Bloomberg L.P.

 

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