Morgan Stanley Sees U.S. Curve Inversion Coming But No Recession

(Bloomberg) — It’s the end of the U.S. yield curve as we know it and Morgan Stanley strategists feel fine.

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Two-year, five-year and 10-year yields will end 2022 at 2.75%, 2.50%, and 2.40% respectively, with inverted curves across the entire Treasury space, strategists including Guneet Dhingra wrote in a note to clients. Traditionally that’s been a harbinger of a recession, though not this time round, they argue.

“We think markets are learning to live with yield curve inversion,” they said, citing the willingness to price restrictive policy rates as well as distortions due to pension demand, QE and an investor flight to quality. “The inversion of the yield curve, on its own, is not sufficient to argue for heightened recession risk in the near term.”

As the inflation-fueling fallout from Russia’s invasion of Ukraine continues, investors are closely watching the yield curve for signals on the growth outlook. With Federal Reserve officials projecting raising interest rates as high as 2.8% by the end of 2023, bond traders are growing increasingly concerned that the economy could buckle under the weight of monetary-policy normalization.

Markets eventually will accept an inverted curve as a natural consequence of interest-rate policy moving toward restrictive territory faster than balance sheet policy approaches neutral territory, the Morgan Stanley strategists said. They do not see a shallow inversion noticably reducing bank loan growth, citing data from previous curve inversions between two- and 10-year yields since 1969.

Still, they see some room for caution in speculative assets. The signal of a restrictive Fed policy embedded in an inverted curve as well as the risk of an earnings recession is likely to weigh on stock markets, they said, even if the curve does not signal an economic recession.

“The Fed, the U.S. economy, the U.S. banking system, and investors can live with an inverted term structure,” they said. “Discussions of an impending recession will continue, but we expect confidence in that view to wane over time.”