Written by Paritosh Bansal
(Reuters) – The bond market anomaly that has so far reliably predicted a U.S. recession could normalize in a highly unusual way this year. This is a cause for concern for the market.
The market signal known as the yield curve has been inverted since early July 2022, with investors locking up their money less for the long term than for the short term. The US benchmark curve shows that the two-year bond yields about 30 basis points higher than the 10-year bond.
Until now, when the Federal Reserve decided to cut interest rates due to economic slowdown and the yields on short-term bonds, which are sensitive to policy interest rates, fell, the yield curve generally trended upward, a phenomenon known as bull steepening. It was a phenomenon.
But this time, it’s starting to look like the curve may normalize as a bearish steepening pushes long-term bond yields higher, according to interviews with six investors and other market experts. became. This is due to pressure on long-term interest rates from rising U.S. debt, but a surprisingly strong economy and persistent inflation are preventing the Fed from cutting rates.
The bear steepening that briefly reared its head in October could return at some point this year, allowing the yield curve to return to normal through a path less trodden.
“What we saw in the second half of 2023 was the beginning of a normalization of the curve,” said Dan Silk, portfolio manager at Janus Henderson. “We plan to achieve a continuation of that theme through the back end of 2024.”
Both the shape of the curve and the reason for its steepness have important implications for the real economy and Wall Street. Investors estimate that the yield on the 10-year Treasury would have to rise above 5% for the curve to normalize, raising interest costs for businesses and consumers. In the bearish expansion scenario, inflation will remain sticky.
While a normal yield curve is favorable for banks, bear steepening can make trading difficult, weighing on stock prices and leading to market volatility.
Furthermore, normalizing the curve does not mean the economy has avoided recession. Rising long-term interest rates could ultimately increase the likelihood of an economic slowdown, and high debt burdens could hamper governments’ ability to respond.
“It would be premature to dismiss this as a false signal,” said Duke University professor Campbell Harvey, who first proposed the inverted yield curve as a recession indicator. “It is negative that long-term interest rates rise.”
Harvey noted that the amount of time it takes for a recession to become apparent after a reversal varies, and that in the last four reversals, the curve turned positive before the recession began.
inch up
Certainly, a bullish steepening can still occur. High policy rates could still slow the economy, weaken the labor market and hurt consumers, potentially leading the Fed to cut rates. High interest rates could cause market turmoil, such as a banking crisis, and force the Fed to cut rates.
But investors said conditions were ripe for the bear market to otherwise steepen. If growth and inflation persist, that would imply an increase in the economy’s long-term equilibrium interest rate, known as the neutral rate, putting pressure on yields. And the huge debt owed by the U.S. government will ultimately force investors to pay more.
There are some signs of investor anxiety in the market. The New York Fed’s model, which breaks down Treasury yields into their components, shows that over time, investors’ premiums on loans are again trickling up.
The term premium turned positive during the bear steepening in October, but fell into negative territory in the second half of the year as the Fed steered the market toward lowering interest rates. It turned positive again this month, most recently on April 24th.
Another indicator of broader concerns is the price of gold and Bitcoin.
Pramol Dhawan, Pimco’s head of emerging markets portfolio management, said demand from public institutions for safe-haven assets has pushed gold prices above its fair value.
That would reduce the number of buyers of U.S. Treasuries even as supply increases.
difficult to predict
But what’s not clear is when those concerns will surface in a market that is currently more focused on the Fed’s interest rate outlook.
While it is difficult to predict events like the UK debt crisis in the fall of 2022, investors said they are keeping an eye on the spending plans of both US political parties as the November election approaches.
BNY Mellon strategist John Bellis said he was concerned about the August repayment announcement, when the Treasury Department revealed its borrowing needs for the quarter. There is not much concern about the May 1st date before that, as tax revenue will reduce the need for funds until the summer.
The bearish steepening is probably a slow process and the timing is uncertain. But it becomes difficult for traders.
Bill Campbell, head of DoubleLine Capital’s global sovereign team, said timing is important because it is costly to trade ahead of a bearish steepening.
Because of this, macro hedge funds are jumping in and out of trades, Campbell said. Investors are also looking at other options, such as reducing the size of trades.
“We’re just trying to find a smart way to put it on,” Campbell said. “In a steepening bear market scenario, we would expect prices to rise further.”
(Reporting by Paritosh Bansal in New York; Editing by Matthew Lewis)
