An inverted yield curve may be signaling the Fed could hit a ‘soft landing,’ not the recession alarm many associate with inversions. Here, a grocery store in Miami.
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The Treasury market is flashing a warning signal about the economy, but some on Wall Street are repeating what John Templeton called the “four most costly words” in investing: This time is different.
It’s a tricky call to make as recession worry seems to be growing by the day, but they could be right.
“I’m in the camp that this time is different, and that’s a hard camp to be in,” said Blake Gwinn, interest-rates strategist with RBC Capital Markets.
First a review of the reason for worry: A bond-market anomaly called a yield curve inversion has shown up recently. Two-year Treasuries yielded more than 10-year notes at the end of trading Monday, closing at 2.42% and 2.4%, respectively. That’s unusual because investors usually demand more compensation for longer-dated Treasuries, to reflect the risk of tighter Fed policy and higher inflation.
The concern around this signal is understandable. In a recent study of yield curve inversions, BCA Research found that the gap between 2- and 10-year yields has inverted before seven of the past eight recessions, with no false signals. The gap between 3-month and 10-year yields has a better record, calling all 8 recessions without a false signal.
But looking under the hood of the bond market shows that one thing is indeed different, and that is the once-in-a-generation inflation that the US is experiencing today.
Remember, Treasury yields reflects the market’s expectations for two things: Fed policy and inflation. And when inflation expectations are stripped out, the yield curve hasn’t inverted, and has kept its upward slope.
A quick comparison to the past three inversions—which were all followed by recessions—shows that the “real yield” curve was fully inverted in 2019 and 2006, and almost perfectly flat in 2000.
This doesn’t general the central idea that the bond market sending today— the Fed will likely cut rates after raising them quickly in an attempt to fight off inflation. Financial markets indicate that the Fed is expected to stop tightening next year, and then make minor rate cuts after that.
But RBC’s Gwinn says that is a sign that global investors believe central bankers can achieve “soft landing,” meaning the Fed will adjust its policy to stave off a broad economic downturn once inflation is under control.
Inflation pricing shows this too: The bond market is reflecting average inflation of 4.4% over the next two years, but a slowdown after that. It reflects 3.4% inflation over the next 5 years, 2.9% over the next decade, and 2.5% over the next 30 years.
It is not guaranteed that a soft landing will occur, of course. If inflation doesn’t moderate, the Fed will have to tighten more and could tip the economy into recession. But the bond market would reflect that change and start sending even stronger warning signals.
That underscores what the bond market and yield curve actually do, and it’s not acting as a crystal ball: The market is just an aggregation of global investors’ expectations for the economy, as Gwinn points out.
“All the yield curve is doing is it reflects back our expectations to us,” he said. “Markets are generally good at pricing an upcoming path of cuts and an upcoming slowdown in inflation.”
Write to Alexandra Scaggs at alexandra.scaggs@barrons.com
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