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Bond markets are flashing warning signs to the US economy.
The precursor is called the “reverse yield curve”. These reversals in the bond market have been reliable predictors of past recessions. Part of the yield curve flipped on Monday.
However, recession is not guaranteed. Some economists consider the warning to be a false alarm.
Here’s what you need to know:
What is a reverse yield curve?
Why is it a warning sign?
A reversal of the yield curve does not cause a recession, but instead suggests that bond investors are worried about the long-term outlook for the economy, Ross said.
Investors pay the most attention to the spread between the two-year US Treasury and the ten-year US Treasury, but the curve hasn’t flashed the warning sign yet.
However, yields on 5-year and 30-year Treasuries reversed for the first time since 2006 on Monday before the Great Recession.
“It doesn’t mean that a recession is coming, it just reflects concerns about the future economy,” Ross said.
According to Roth, the Treasury yield curve for the two and ten years reversed before the last seven recessions since 1970.
However, data show that if a recession becomes a reality, an imminent recession is unlikely to occur. It took an average of 17 months from the bond market reversal to the onset of a recession (Roth’s analysis treats the double-bottom recession of the 1980s as a recession).
She said there was one false alarm in 1998. There was a reversal shortly before the Covid-19 pandemic, but bond investors couldn’t predict the health crisis, so Ross could definitely be seen as a false alarm.
Brian Luke, Head of Fixed Income in the Americas of the S & P Dow Jones Index, said:
Interest rates and bonds
The Federal Reserve System, the central bank of the United States, has a significant impact on bond yields.
According to Luke, the Fed’s policies (that is, its benchmark interest rates) generally have a direct impact on short-term bond yields compared to long-term bonds.
Long-term bonds are not always tied to the Fed’s benchmark (called the federal funds rate). Instead, investor expectations for future Fed policies will have a greater impact on long-term bonds, Luke said.
The central bank of the United States raised benchmark interest rates in March, cooling the economy and curbing inflation, the highest level in 40 years. More is expected this year.
This has led to higher yields on short-term bonds and higher yields on long-term bonds, but not much.
Yields on 10-year Treasuries were about 0.13% higher than Monday’s 2-year bonds, with spreads much higher in early 2022 (0.8%).
Investors are concerned about the so-called “hard landing,” according to market experts. This would happen if the Fed raised interest rates too aggressively to curb inflation and accidentally caused a recession.
During a recession, the Fed lowers benchmark interest rates to drive economic growth (lowering reduces individual and corporate borrowing costs, but raising them has the opposite effect).
Therefore, the reverse yield curve suggests that investors are looking at a recession in the future and are therefore pricing in anticipation of the Fed’s rate cuts in the long run.
“It’s the bond markets that are trying to understand the future course of interest rates,” said Preston Coldwell, head of the US economic sector at Morningstar.
Government bonds are considered a safe asset, as the United States is unlikely to default, according to Luke.
Is there a possibility of recession?
Recession is not a natural conclusion.
The Federal Reserve has the potential to properly adjust interest rate policies and achieve the goal of a “soft landing.” This suppresses inflation and does not cause the economy to shrink. Prices for commodities such as oil and food.
“There is nothing magical about the yield curve reversal,” Caldwell added, adding that it does not mean that the economy will shrink.
However, many economists are adjusting their economic forecasts. JP Morgan has set the odds of a recession at about 30% to 35%. This is up from the historical average of about 15%, Ross said.