Bond-market recession gauge plunges to triple digits below zero on way to fresh four-decade milestone

One of the bond market’s most reliable gauges of impending U.S. recessions plunged further below zero into triple-digit negative territory on Tuesday after Federal Reserve Chairman Jerome Powell pointed to the need for higher interest rates and a possible reacceleration in the pace of hikes.

The widely followed spread between 2- and 10-year Treasury yields plunged to minus 104.6 basis points during New York afternoon trading and headed for a level not seen since Sept. 22, 1981, when it reached minus 121.4 basis points and the fed funds rate was 19% under then-Federal Reserve Chairman Paul Volcker.

Powell surprised financial markets on Tuesday in more hawkish comments than many expected, which sent the policy-sensitive 2-year rate above 5%, all three major stock indexes
DJIA,
-1.57%

SPX,
-1.40%

COMP,
-1.16%

down, and the ICE U.S. Dollar Index up by almost 1.2% to its highest level since January.

Meanwhile, traders boosted the odds of a half-of-a-percentage point rate hike on March 22, to 70.5% from 31.4% a day ago, and saw a growing chance that the fed funds rate will end the year between 5.5% and 5.75% or higher, according to the CME FedWatch Tool.

“Every time the Fed gets more hawkish, the curve gets more inverted, which is the market’s way of saying there will be Fed rate cuts later because of a slowdown in growth and/or a recession,” said Tom Graff, head of investments for Facet in Baltimore, which manages more than $1 billion. “It tells you what the market thinks about the sustainability of keeping rates this high for a long time, and the market still thinks a recession is pretty likely but not necessarily imminent.”

An inverted 2s/10s spread simply means that the policy-sensitive 2-year rate
TMUBMUSD02Y,
5.010%

is trading far above the benchmark 10-year yield
TMUBMUSD10Y,
3.972%
,
as traders and investors factor in higher interest rates in the near term and some combination of slower economic growth, lower inflation, and possible interest-rate cuts over the longer term. Tuesday’s triple-digit inversion was largely driven by the rise in the 2-year rate, which was on its way to ending the New York session above 5% for the first time since Aug. 14, 2006.

The 2s/10s spread first went below zero last April, only to un-invert again for a few months before dropping further into negative territory since June and July. It is just one of more than 40 Treasury-market spreads that were below zero as of Monday, but is regarded as one of the few with a reasonably reliable track record of predicting recessions, albeit with a one-year lag on average and at least one false signal in the past.

Via phone, Graff said that “I don’t think the power of yield-curve inversion as a signal has changed at all. Every slowdown and every cycle is a little different so how it plays out is a little different. But that signal is just as powerful and accurate as ever. I think the economy is going to slow meaningfully in the second half of this year, but not fall into recession until 2024.” Meanwhile, Facet has been overweight on healthcare and established technology companies with higher profit margins, lower debt levels and less variability in their earnings than in the past, he said.

As a result of Powell’s testimony, the 1-year T-bill rate jumped by more than any other rate, to 5.26%, while the 6-month T-bill rate went to 5.22% on Tuesday. The Fed chairman’s focus on the need for higher rates came as lawmakers repeatedly asked him whether interest rates are the only tool available to policy makers for controlling inflation. Powell replied that interest rates are the main tool, demurring from an opportunity to discuss the Fed’s quantitative tightening process — or shrinking of the central bank’s $8.34 trillion balance sheet — in more detail.

QT was once seen as a supplement to rate hikes, with one economist at the Fed’s Atlanta branch estimating that a $2.2 trillion passive roll-off of nominal Treasury securities over three years would be equivalent to a 74 basis point rate hike during turbulent times.

But tinkering with QT now and accelerating the pace of that process would be a “can of worms the Fed doesn’t really want to open, “said Marios Hadjikyriaco, senior investment analyst at Cyprus-based multiasset brokerage XM. That would “drain excess liquidity out of the system and tighten financial conditions faster, helping to transmit the stance of monetary more effectively, but the scars of the ‘taper tantrum’ and the 2019 repo crisis have made Fed officials wary of deploying this tool in an active manner.”

According to Facet’s Graff, last year’s bond-market crisis in England — when a surprising large package of tax cuts from the U.K. government triggered tumult and led to an emergency intervention by the Bank of England — is also playing a factor in the Fed’s thinking. “If the Fed got too aggressive with QT, it might have unpredictable outcomes,” Graff said. “And given that the Fed hasn’t said anything about it, the market has kind of forgotten about quantitative tightening as a tool, honestly, right or wrong.”

Source: https://www.marketwatch.com/story/bond-market-recession-gauge-plunges-to-triple-digits-below-zero-on-way-to-fresh-four-decade-milestone-41448336?siteid=yhoof2&yptr=yahoo