One of the bond market’s most reliable indicators of impending U.S. recessions dipped further into triple-digit negative territory on Wednesday, as Federal Reserve Chairman Jerome Powell reiterated the need for higher interest rates. high and a possible reacceleration of the rate of increases.
The widely followed spread between 2- and 10-year Treasury yields was minus 106.7 basis points in morning trade in New York, after ending at minus 103.7 basis points on Tuesday – a level not seen before. since September 22, 1981. The spread has reached minus 121.4. basis points on this date more than 40 years ago, when the federal funds rate was 19% under Paul Volcker, then chairman of the Federal Reserve.
A negative 2s/10s spread simply means that the policy-sensitive 2-year rate BX:TMUBMUSD02Y is trading well above the benchmark 10-year yield BX:TMUBMUSD10Y, as traders and investors price in higher yields. higher short-term interest rates and some combination of slower economic growth, lower inflation and possible declines in longer-term interest rates.
Powell surprised financial markets in his first day of congressional testimony on Tuesday with more hawkish comments than many expected, sending the policy-sensitive 2-year rate above 5%. As his second day of testimony unfolded before the House Financial Services Committee, major U.S. stock indexes
were mixed and the ICE US Dollar Index
remained close to its highest level of the year.
Meanwhile, fed funds futures showed traders seeing a 70.5% chance of a half-percentage-point rate hike by the Fed on March 22, down from 31.4%. % at the start of this week, and saw a better than unlikely chance that the fed funds rate will be between 5.5% and 5.75%, or higher, by November, according to the CME FedWatch Tool.
“Each time the Fed gets more hawkish, the curve inverts more, which is the market’s way of saying there will be Fed rate cuts later on due to slower growth and /or a recession,” said Tom Graff, chief investment officer for Facet in Baltimore, which manages more than $1 billion. “That 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 quite likely but not necessarily imminent.”
Tuesday’s triple-digit reversal was largely driven by the rise in the 2-year rate, which ended the New York session above 5% for the first time since June 18, 2007, according to Tradeweb and Dow Jones. MarketData.
On Wednesday, the momentum changed: most yields were down, but the Treasury curve nonetheless deepened its inversion. That’s because the reversal this time around was fueled by the 10-year rate falling at a faster pace relative to the 2-year yield, sending the spread between the two even further into negative territory.
Meanwhile, Powell expanded on the Fed’s thinking on Wednesday, telling the House committee that policymakers hadn’t made any decisions about their March meeting, weren’t on a “predefined path” and still had data. potentially big ones to come in the next two weeks – including Friday’s US jobs report for February and next week’s consumer and producer price indices.
As Powell testified, the BX:TMUBMUSD03M 3-month Treasury bill rate jumped to 4.99%, while the BX:TMUBMUSD06M 6-month Treasury bill rate rose to 5.26 %.
The 2s/10s spread first fell below zero last April, then did not reverse for a few months before falling back into negative territory since June and July. It’s just one of more than 40 Treasury market spreads that were below zero on Tuesday, but it’s considered one of the few with a reasonably reliable history of predicting recessions, though with an average lag of one year and at least one false signal in the past.
Over the phone, Graff said, “I don’t think the strength of the 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 this signal is still just as powerful and precise. I think the economy will slow down significantly in the second half of this year, but won’t fall into recession until 2024.” Meanwhile, Facet was overweight health care and established tech companies with profit margins. higher, lower debt levels and less variability in their earnings than in the past, he said.
The Fed Chairman’s emphasis on the need for higher rates came as lawmakers repeatedly asked him on Tuesday whether interest rates were the only tool policymakers had to control inflation. . Powell responded that interest rates are the primary tool, hesitant to discuss the Fed’s process of quantitative tightening in more detail — or the central bank’s $8.34 trillion balance sheet reduction.
QT was once seen as a complement to rate hikes, with an economist at the Fed’s Atlanta branch estimating that a passive roll-off of $2.2 trillion in nominal Treasuries over three years would equate to a hike rates of 74 basis points in turbulent times. .
But tinkering with QT now and accelerating the pace of that process would be a “Pandora’s box that the Fed doesn’t really want to open,” said Marios Hadjikyriacos, senior investment analyst at Cyprus-based multi-asset brokerage XM. This “would drain excess liquidity from the system and tighten financial conditions more quickly, helping to transmit monetary policy stance more effectively, but the scars of the ‘crisis crisis’ and the 2019 pension crisis have rendered Fed officials hesitant to actively deploy this tool.
See: The secret to the actions’ success so far in 2023? An unexpected $1 trillion increase in liquidity by central banks.
According to Facet’s Graff, last year’s bond market crisis in England – when a surprising set of UK government tax cuts sparked an uproar and led to an emergency intervention by the Bank of England – could also play a role in Fed thinking. .
“If the Fed got too aggressive with QT, it could have unpredictable results,” Graff said. “And given that the Fed hasn’t said anything about it, the market kind of forgot about quantitative tightening as a tool, honestly, rightly or wrongly.”