The bond market is signaling a higher chance of recession at the same time it is pricing in more Federal Reserve interest rate hikes. Market pros have been watching the yield curve get flatter for weeks, as fears mount that a recession is lurking — either because the Fed hikes rates too aggressively or the high price of oil and other necessities stall out growth. A flattening yield curve simply means that shorter duration Treasurys have higher yields than longer duration issues. For instance, the two-year yield is getting much closer to the 10-year yield. That spread is very closely watched and was just 22 basis points [or 0.20 percentage points] apart on Tuesday. The two-year note was yielding 2.15% Tuesday afternoon, while the 10-year yield was at 2.37%. The last time that part of the curve was inverted was in August 2019. A flattening curve signals a slowing economy, while an inverted curve raises the odds of a recession. Part of the curve was inverted Tuesday, with the three-year Treasury note yield and five-year Treasury note yield both slightly higher than the 10-year yield. After an unusually hawkish speech from Fed Chair Jerome Powell Monday, Treasury yields moved higher and the curve flattened further. The fed funds futures market moved to price in back-to-back 50 basis points, or 0.50, rate hikes in May and June. Futures also priced in the fed funds rate reaching 2.25% by the end of this year and peaking at 2.75% by September 2023. "There's no way to get around the idea that historically abruptly flattening curves typically precede recessions," said Ralph Axel, director rates research at Bank of America. "However, you can say there are long lags, and it's quite possible that the Fed cuts rates early and the Fed proactively tries to be very careful like they were in 2019." Were it not for the pandemic, the Fed probably would have avoided a recession and would have extended the recovery with its 2019 rate cuts, Axel said. The pandemic shut down the economy and resulted in an extremely sharp but swift recession in early 2020. Axel said that even though the widely watched two-year to 10-year section of the curve is not yet inverted, it is closely correlated to the three-year and five-year section and they all eventually move together. "The fact that 2s/10s are 20 basis points apart shouldn't be some kind of a calming sign that conditions are fine. It's flat. You might as well call it zero. The curve has flattened like a pancake," he said. But even though the signal is recession, it doesn't mean there will be one any time soon. Economists say the odds of a recession are rising, but most are not forecasting one. "It just means the market is anticipating the Fed is going to do its job and actually slow growth, and if that actually works and it cools off growth and it also cools off wages, then they get to a place where they can start cutting rates again and avoid a recession," said Axel. Morgan Stanley projects a 27% chance of recession over the next two years. "This environment is so atypical, where the Fed is behind the curve and they clearly are going to be very, very aggressive. A flatter or inverted curve has been a coincidence indicator, not a leading indicator," said Jim Caron, head of macro strategies for global fixed income at Morgan Stanley Investment Management. Ultimately, higher rates could lead to a recession, but not necessarily. "If the Fed gets what they want and inflation starts to come down, then great, but what the Fed's telling you is if they don't get what they want and inflation doesn't come down, they're going to do more and that's when we start to worry about a recession," Caron said. Michael Schumacher, director of rate strategy at Wells Fargo, said a flattening curve is no longer the economic messenger it once was. "The yield curve was a good predictor prior to the global financial crisis, but not anymore. The massive bond purchases by central banks have distorted the yield curve so much that it no longer sends a reliable signal on recession," he said.
Traders on the floor of the NYSE, March 1, 2022.
The bond market is signaling a higher chance of recession at the same time it is pricing in more Federal Reserve interest rate hikes.