Concerns about the risk of economic recession

FED hiked rates for the first time at March meeting

Curve inversion is usually seen as a pretty reliable guide to recession in the US. But will it prove so in this instance? The first point Mr. Steve Barrow, Head of Standard Bank G10 Strategy, would make about the inversion right now is that it is taking place against the backdrop of very low policy rates with the fed funds target far below what’s considered "neutral" for the economy and even further below the near-twelve percent growth rate of nominal GDP in Q4. Even if you plug in market expectations for future policy rates to rise over the next couple of years, it is still hard to argue that curve inversion is consistent with the idea that the Fed is likely to overdo monetary tightening and so plunge the economy into a recession.

Naysayers might argue that the last time the 10s-2s curve inverted in August 2020, a recession followed, even though policy rates were quite low then too. But that was the COVID recession, and that sort of shock is bound to cause a recession whether the yield curve inversion ‘predicted’ it or not. If we go further back into the 1980s and 90s, it seems that the curve’s ability to predict a recession was based on the fact that inversion reflected tight policy. In fact, you have to go back to the high inflation period of the 1970s to see when inversion occurred against the backdrop of loose policy – and that resulted in surging inflation that eventually had to be halted by a dramatic hike in policy rates; a possible guide to what lies ahead now.

As far as we see it, a sufficient tightening of financial conditions to contain inflation will come in one (or both) of two ways. Either the Fed will have to tighten policy more substantially than is currently priced into the curve, or else the market will do the work of tightening conditions through significant asset price weakness whereby equities slump, credit spreads surge, and more. Right now, the flat curve might be saying that there’s more chance of the latter than the former.

Curve inversion is usually seen as a pretty reliable guide to recession in the US.

In Mr. Steve Barrow’s view, a second concern that he has about the curve inversion is that it might reflect undue optimism on the part of investors about lower inflation in the future given the low level of long-term yields. So far, any such optimism seems to have been misplaced, although many will argue that it is early days yet. Should inflation remain persistent, there has to be a danger that longer-term yields will move up aggressively.

In addition, Mr. Steve Barrow doesn’t know the extent to which QE is exerting downward pressure on long-term rates, thus opening the possibility of much higher yields ahead as the Fed starts to sell its huge bond portfolio. Yet another concern relates to the dollar. While it is usually argued that increases in the fed funds rate will help lift the dollar, particularly if other central banks run a more quiescent policy, much depends on longer-term rates as well. For example, if the yield gap between long-term rates and funding rates is narrow (or even negative), it may reduce overseas demand for treasuries, weighing on the dollar.Of course, much depends here on the shapes of the curves in other countries, not just the US. But should the inversion detract from the dollar, it could prevent the sort of rise in the greenback that policymakers need to bear down on rampant inflation.

"It should be clear by now that there are lots of issues raised by the inversion of the 10s-2s yield curve in the US. While we are not too concerned that the inversion indicates an immediate economic risk to the economy, we do believe that it reflects a number of financial market problems that could easily flare up in the future, such as asset price implosion and dollar weakness that could cause a recession down the line. Put more simply, we should not be concerned that an inversion shows that the market thinks the Fed is doing too much monetary tightening, but that it is likely to do too little", Mr. Steve Barrow said.