Bond market recession gauge dips further into triple digits below zero after hitting four-decade milestone

A negative 2s/10s spread simply means that the policy-sensitive 2-year rate BX:TMUBMUSD02Y is trading well above the benchmark 10-year rate BX:TMUBMUSD10Y as traders and investors factor in higher short-term interest rates and a combination of slower economic growth, lower inflation and possible interest rate cuts in the longer term.

Powell surprised financial markets during his first day of congressional testimony on Tuesday with more aggressive remarks than many expected, pushing policy-sensitive 2-year yields above 5%. While his second day of prosecution took place before the House Financial Services Committee, the major US stock indexes

DJIA

SPX

COMP

were mixed and the ICE US Dollar Index

DXY

remained near the year’s highest level.

Meanwhile, fed-funds futures showed that traders see a 70.5% chance of a half percentage point rate hike by the Fed on March 22, compared to 31.4% at the start of this week, and saw a higher chance then not. that the fed-funds rate will be between 5.5% and 5.75% or higher in November, according to the CME FedWatch Tool.

“Every time the Fed gets more aggressive, the curve gets more inverted, which is the market’s way of saying there will be Fed rate cuts later because of a slowdown and/or a recession,” said Tom Graff, chief investment officer. for Facet in Baltimore, which manages more than $1 billion. “It tells you what the market thinks about the sustainability of keeping interest rates 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 2-year yields, which ended above 5% for the first time since June 18, 2007, according to Tradeweb and Dow Jones Market Data.

On Wednesday, the dynamics changed with most yields falling, but the Treasury curve nevertheless deepened its inversion. That’s because this time the inversion was fueled by the 10-year rate falling faster against the 2-year rate, pushing the spread between the two even further into negative territory.

Meanwhile, Powell expanded on the thoughts of the Fed on Wednesday, telling the House of Representatives committee that policymakers have not yet made decisions about their March meeting, are not on a “predetermined path” and may still important data will be expected in the next meeting. two weeks — including Friday’s US jobs report for February and next week’s consumer and producer price indices.

As Powell’s testimony progressed, the 3-month T-bill rate BX:TMUBMUSD03M rose to 4.99%, while the 6-month T-bill rate BX:TMUBMUSD06M rose to 5.26%.

The 2s/10s spread went below zero for the first time last April, before reverting for a few months before sinking further 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 is considered one of the few with a fairly reliable record for predicting recessions, albeit delayed by an average of a year and at least one false. signal in the past.

Over the phone, Graff said, “I don’t think the strength of yield curve inversion as a signal has changed at all. Every delay and every cycle is a little different, so how it plays out is a little different. But that signal is as powerful and accurate as ever. I think the economy will slow significantly in the second half of this year, but will not enter a recession until 2024.” Meanwhile, Facet is overweight healthcare and established technology companies with higher profit margins, lower debt and less variability in their earnings than in the past, he said.

The Fed chairman’s focus on the need for higher rates came as lawmakers asked him repeatedly on Tuesday whether interest rates are the only tool available to policymakers to manage inflation. Powell replied that interest rates are the most important tool, objecting to an opportunity to discuss the Fed’s quantitative tightening process — or shrinking the central bank’s $8.34 trillion — balance sheet in more detail.

QT was once seen as a complement to rate hikes, with an economist at the Fed’s Atlanta branch estimating that a $2.2 trillion passive roll-off of nominal government bonds over three years would equate to a rate hike of 74 percent. basis points in turbulent times. .

But tinkering with QT now and accelerating the pace of that process would be a “can of worms that the Fed doesn’t really want to open,” said Marios Hadjikyriacos, senior investment analyst at Cyprus-based multi-asset brokerage XM. That would “drain excess liquidity from the system and tighten financial conditions more quickly, which would help communicate monetary stance more effectively, but the scars of the 2019 taper tantrum and repo crisis have made Fed officials wary to deploy this tool in an active way.”

To see: The secret to stocks’ success so far in 2023? An unexpected $1 trillion liquidity boost from central banks.

According to Facet’s Graff, last year’s bond market crisis in England – when a surprisingly large package of tax cuts from the British government caused a stir and led to an emergency intervention by the Bank of England – may also play a role in the Fed’s thinking . .

“If the Fed gets too aggressive with QT, it could have unpredictable results,” Graff said. “And given that the Fed hasn’t said anything about it, the market has kind of forgotten about quantitative tightening as a tool, frankly, right or wrong.”