Bond market fireworks highlight recession worries

[March 22, 2022]  By Davide Barbuscia

NEW YORK (Reuters) -Sharp moves in the U.S. Treasury market are increasingly pointing to the risk of an approaching recession, with "bond vigilantes coming out of the woodwork" and markets doubting the U.S. Federal Reserve's plan to engineer a "soft landing" for the economy as it hikes interest rates to fight inflation, market experts said.

Fed Chair Jerome Powell said on Monday the U.S. central bank must move "expeditiously" to bring too-high inflation to heel and that it could use bigger-than-usual interest rate hikes if needed. Bond yields, which move inversely to prices, spiked while the U.S. Treasury yield curve continued its flattening trend.

"The market seems to be challenging the soft-landing view for the U.S. economy that the Fed argued at the March FOMC meeting", BofA strategists said.

The U.S. Treasury yield curve reflects "recession risks, and not just through the curve's extreme flatness at the inception of the Fed tightening cycle," the strategists said.

The closely followed part of the yield curve measured between 10-year and two-year Treasuries has narrowed by about 60 basis points since the start of the year, with the longer-dated notes now yielding less than 20 basis points more than two-year debt.

Any inversion of that part of the curve, when shorter notes yield more than longer ones, is generally seen as presaging a recession by six to 24 months.

"The yield curve does look ominous," wrote Christopher Murphy, Co-Head of Derivatives Strategy at Susquehanna Financial Group, although he said an inversion does not always guarantee a recession.

Melissa Brown, Global Head of Applied Research at Qontigo, said the yield curve is reflecting a shift in market views on the ability of the Fed to tighten monetary policy just enough to reduce inflation without throwing the economy into a recession.

"The market perhaps is assuming that they can't thread that needle ... it's going to be tough to not drive us into recession", she said.

Still, Powell on Monday said he did not see an elevated likelihood of a recession in the next year and others are skeptical of such an event.

That prompted Federal funds rate futures on Monday to raise the chances of a half percentage-point tightening at the next policy meeting in May.

Analysts at NatWest said Powell was clearly "warning of risks to 50bp hike(s) at the coming meetings," which they said sent Treasuries into "free fall."

When asked on Monday about concerns on what the yield curve is saying, Powell said that he focused on the short end of the curve, meaning the first 18 months of maturities.

A security guard walks in front of an image of the Federal Reserve following the two-day Federal Open Market Committee (FOMC) policy meeting in Washington, March 16, 2016. REUTERS/Kevin Lamarque

Morgan Stanley said in a research note on Sunday that an inversion of the yield curve was possible in the second quarter this year, but that an inversion does not necessarily anticipate a recession.

"However, it does support our view for sharply decelerating earnings growth", it said.

For Tim Holland, chief investment adviser at Orion Advisor Solutions, a recession is not imminent, despite the flat curve.

Another part of the curve which compares three-month bills with 10-year notes has steepened this year, from 145 basis points on Dec. 31 to 181.54 basis points on Monday.

"If the past 30 years is any guide, both parts of the curve need to flatten and invert before we are at risk of recession", he said.

Powell's speech on Monday at a National Association for Business Economics conference caught some market participants off guard as they seemed more hawkish than his remarks after the Fed last Wednesday raised the federal funds rate by 25 basis points.

Yields spiked on Monday with the 10-year benchmark note up to a yield of 2.298% from 2.153% on Friday - the highest since May 2019. Yields of two-year Treasuries, which more closely reflect monetary policy expectations, jumped to 2.111% from 1.942% on Friday.

"What you saw today is Powell basically throwing the towel, he said he's going to do whatever it takes, and it took the market a little bit back", said Andrew Brenner, head of international fixed income at National Alliance Securities.
 

Brenner described the bond market behaviour as that of bond vigilantes - when investors insist on high yields to compensate for the risk of inflation.

"Bond vigilantes have come out of the woodwork," Brenner said, adding he saw a large amount of selling in the futures market, particularly concentrated in five-year futures.

(Reporting by Davide Barbuscia; additional reporting by Alden Bentley; Editing by Megan Davies, Hugh Lawson and Bernard Orr)

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