Deepest Bond Yield Inversion Since Volcker Suggests Hard Landing

(Bloomberg) — The bond market is doubling down on the prospect of a US recession after Federal Reserve Chair Jerome Powell warned of a return to bigger interest-rate hikes to cool inflation and the economy.

Most Read from Bloomberg

As derivative contracts referencing the next four Fed policy meetings repriced to levels consistent with the central bank benchmark rate rising by another full percentage point, the yield on the two-year Treasury note climbed as much as 13 basis points on Tuesday to 5.02%, its highest level since 2007. Critically though, longer-dated yields remained stalled; the 10- and 30-year rates ended little changed on the day under 4% despite auctions of those tenors later this week.

As a result the closely watched relationship between 2- and 10-year yields exceeded a percentage point for the first time since 1981, when then-Fed Chair Paul Volcker was engineering rate hikes that broke the back of double-digit inflation at the cost of a lengthy recession. A similar dynamic is unfolding now, according to Ken Griffin, the chief executive officer and founder of hedge fund giant Citadel.

“We have the setup for a recession unfolding” as the Fed responds to inflation with rate increases, Griffin said in an interview in Palm Beach, Florida.

Longer-dated Treasury yields have failed to keep pace with the surging two-year benchmark since July, creating a so-called curve inversion that over the decades has amassed an impressive record of anticipating recessions in the wake of aggressive Fed tightening campaigns.

In general, curve inversions have preceded economic downturns by 12 to 18 months, and the odds of another chapter are only intensifying after Powell’s comment indicating openness to reverting to half-point rate hikes in response to resilient economic data. The Fed’s quarter-point hike on Feb. 1 was the smallest since the early days of the current tightening campaign.

Traders upgraded the odds of a half-point rate increase on March 22 from about one-in-four to around two-in-three, raising the stakes for February employment data set to be released on Friday, and the February consumer price index in around a week’s time.

“Rate volatility will be with us until the Fed is really done,” said George Goncalves, head of US macro strategy at MUFG. “Higher vol means you have to derisk and put more of a risk premia back into credit and equities.”

US stocks extended the decline they’ve been suffering over the past month, with the S&P 500 Index notching a 1.5% drop, its biggest in two weeks. Hopes that the Fed might be near the end of its tightening cycle had boosted the S&P 500 by over 6% in January, but stubbornly high inflation and the Fed’s resolve to fight it has since dragged equities back down.

Meanwhile the dollar, which tends to benefit from both elevated short-end interest rates and a bid for safety when times are tough, also surged higher Tuesday, with a Bloomberg gauge of the currency rising to its highest level since early January.

“It is hard to deny the hawkishness of the statement and the message that markets took away,” strategists at NatWest Markets wrote in a note to clients. Powell “firmly opened the door” for a return to 50-basis-point moves, although the Fed chair emphasized the importance of upcoming data releases in making that determination and “these are likely to be high vol events,” according to strategists Jan Nevruzi, John Briggs and Brian Daingerfield.

Powell told members of Congress on Tuesday that there are “two or three more very important data releases to analyze” ahead of the March deliberations, and “all of that will go into making the decision.”

Also in March, Fed policy makers are set to release updated quarterly forecasts for where various officials see interest rates going, also known as the dot plot. In December, the median projection was for a peak of around 5.1% and a long-run neutral rate of 2.6%.

Some investors think a recession can be averted even as growth slows. Either way, longer-dated Treasuries are viewed as a viable shelter with the Fed still raising rates.

Short-maturity yields are “most vulnerable to repricing higher,” especially if wage growth resumes rising, favoring a half-point rate increase, said Ed Al-Hussainy, rates strategist at Columbia Threadneedle Investments. That will drive “more flattening pressure on the curve.”

–With assistance from Edward Bolingbroke, Katie Greifeld and Felipe Marques.

Most Read from Bloomberg Businessweek

©2023 Bloomberg L.P.

Source: https://finance.yahoo.com/news/deepest-bond-yield-inversion-since-230000311.html