In the Market: Economic surprises are messing with the market's favorite
recession predictor
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[April 29, 2024] By
Paritosh Bansal
(Reuters) -A bond market anomaly that has reliably predicted a U.S.
recession in the past may normalize this year in a highly unusual
manner. It's a worry for markets.
The market signal, called a yield curve, has been upside down since
early July 2022, with investors getting less to lock up their money for
longer periods than they are for shorter durations. The benchmark U.S.
curve shows yields on 2-year Treasuries are about 30 basis points higher
than 10-year bonds.
In the past, yield curves typically become right-side up as an economic
slowdown leads the Federal Reserve to cut interest rates, bringing down
yields on near-term bonds that are sensitive to policy rates, a
phenomenon called bull steepening.
This time around, though, it is starting to look like the curve may
normalize because longer-term bond yields would rise in a bear
steepening, interviews with half a dozen investors and other market
experts show. That is due to pressure on longer-term rates from
increasing U.S. debt, while a surprisingly robust economy and sticky
inflation keep the Fed from cutting rates.
A bear steepening, which briefly reared its head in October, could
resume at some point this year, leading the yield curve back to normal
through a rarely trodden path.
"What we saw in the later stages of 2023 was the beginning of that curve
normalization," said Dan Siluk, a portfolio manager at Janus Henderson.
"We'll get a continuation of that theme through the back end of 2024."
Both the shape of the curve and the reasons for its steepening have
important implications for the real economy and Wall Street. The yield
on 10-year Treasury bonds would have to rise above 5% for the curve to
normalize, the investors estimated, which raises interest costs of
businesses and consumers. Inflation would remain sticky in a
bear-steepening scenario.
While a normal yield curve is good for banks, a bear steepening would be
hard to trade and pressure stocks, leading possibly to market swings.
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Moreover, the normalization of the curve would not mean the economy had
dodged a recession. Higher long-term rates could make an eventual
slowdown more likely, and a high debt load would hamper the government's
ability to respond.
"It's too early to dismiss this as a false signal," said Campbell
Harvey, a Duke University professor who first proposed the inverted
yield curve as a recession indicator. "It is negative that long-term
rates go up."
Harvey pointed out that the time it takes for a downturn to manifest
after inversion varies, and that in the four most recent inversions the
curve turned positive before a recession started.
INCHING HIGHER
To be sure, a bull steepening could also still happen. High policy rates
could still slow down the economy, weaken the labor market and hurt
consumers, leading the Fed to cut rates. High interest rates could also
cause a market ruction, like a banking crisis, that forces the Fed to
lower rates.
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But investors said absent that, conditions were building up for a
bear steepening. If growth and inflation persist, it would suggest
the long-run equilibrium interest rate for the economy, called the
neutral rate, is higher, putting pressure on yields. And the immense
amount of debt the U.S. government is taking on would eventually
lead investors to charge more for it.
There are some signs of investor worries in markets. A New York Fed
model that breaks down Treasury yields into its components shows the
premium investors charge for lending money over time has been
inching up once again.
The term premium had turned positive during the October bear
steepening, but fell into negative territory later that year as the
Fed pivoted to guiding the market on lower rates. It turned positive
again this month, most recently on April 24.
Another indicator of the broader concern: the price of gold and
bitcoin.
Pramol Dhawan, head of Pimco's emerging markets portfolio
management, attributed an increase in the price of gold over its
fair value due to demand from official institutions for safe-haven
assets.
That would reduce buyers of Treasuries even as supply increases.
HARD TO PREDICT
What is not clear, though, is when these concerns will become front
and center for markets, which are more focused on the Fed rate
outlook at the moment.
An event like the UK’s debt crisis of autumn 2022 is hard to
predict, although investors said they were watching for spending
plans of both U.S. political parties as the November election
approaches.
BNY Mellon strategist John Velis said they were concerned about the
Treasury Department's August refunding announcement, in which it
lays out the borrowing needs for the quarter. The one before that on
May 1 is of less concern as tax receipts would have lessened the
need for funding through the summer.
More likely, a bear steepening would be a slow process with
uncertain timing. That, however, makes it harder for traders.
Bill Campbell, who heads DoubleLine Capital's global sovereign team,
said it is costly to put trades ahead of a bear steepening, so
timing becomes important.
That is leading macro hedge funds to go in and out of the trade,
Campbell said. Investors are also looking at other ways, such as
using smaller trade sizes.
"You're just trying to find clever ways to put it on," Campbell
said. "In the bear steepening scenario, we think it's going to be
more of a grind higher."
(Reporting by Paritosh Bansal in New YorkEditing by Matthew Lewis)
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