One of the bond market’s most reliable gauges of impending U.S. recessions plunged further into triple-digit negative territory on Wednesday, as Federal Reserve Chairman Jerome Powell reiterated the need for higher interest rates and a possible reacceleration in the pace of hikes.
The widely followed spread between 2- and 10-year Treasury yields finished the New York session at minus 109 basis points, a day after ending in triple-digit negative territory for the first time since Sept. 22, 1981.
A negative 2s/10s spread simply means that the policy-sensitive 2-year rate BX:TMUBMUSD02Y is trading far above the benchmark 10-year yield BX:TMUBMUSD10Y, as traders and investors factor in higher interest rates in the near term and some combination of slower economic growth, lower inflation, and possible interest-rate cuts over the longer term. The spread hasn’t been this deeply inverted since it reached minus 121.4 basis points more than 40 years ago, when the fed-funds rate was 19% under then-Federal Reserve Chairman Paul Volcker.
Powell surprised financial markets during his first day of congressional testimony in front of the Senate Banking Committee on Tuesday with more hawkish comments than many expected, sending the policy-sensitive 2-year rate above 5%. After his second day of testimony on Wednesday before the House Financial Services Committee, the 2-year yield jumped even further above 5%, to 5.06%, while the ICE U.S. Dollar Index DXY — which moves in tandem with U.S. rate expectations relative to the rest of the world — rose to its highest level of the year. Major U.S. stock indexes DJIA SPX COMP finished mostly higher.
Meanwhile, fed-funds futures traders boosted the likelihood of a half-percentage-point rate hike by the Fed on March 22, to 79.4% from 31.4% at the start of this week, and they factored in a better-than-not chance that the fed-funds rate will get to between 5.75% and 6%, or higher, by September, according to the CME FedWatch Tool.
Read: Stock market could ‘take it hard’ as expectations grow for a 6% fed funds rate
“Every time the Fed gets more hawkish, the curve gets more inverted, which is the market’s way of saying there will be Fed rate cuts later because of a slowdown in growth and/or a recession,” said Tom Graff, head of investments for Facet in Baltimore, which manages more than $1 billion. “It tells you what the market thinks about the sustainability of keeping rates this high for a long time, and the market still thinks a recession is pretty likely but not necessarily imminent.”
This week’s triple-digit inversion in the 2s/10s spread was largely driven by the rise in the 2-year rate, which ended the New York session above 5% on Tuesday for the first time since June 18, 2007, according to Tradeweb and Dow Jones Market Data.
The 2-year yield went further above 5% on Wednesday despite Powell’s efforts to clarify the Fed’s thinking, by telling the House committee that policy makers haven’t made any decisions about their March meeting, are not on a “preset path,” and still have potentially important data coming up in the next two weeks — including Friday’s U.S. jobs report for February and next week’s consumer and producer price indexes.
After Powell’s testimony ended on Wednesday, the 3-month T-bill rate BX:TMUBMUSD03M jumped to 5%, while the 6-month T-bill rate BX:TMUBMUSD06M went up to 5.28%.
The 2s/10s spread first went below zero last April, only to un-invert again for a few months before dropping further into negative territory since June and July. It is just one of more than 40 Treasury-market spreads that were below zero as of Wednesday, but is regarded as one of the few with a reasonably reliable record of predicting recessions, albeit with a one-year lag on average and at least one false signal in the past.
Via phone, Graff said that “I don’t think the power of yield-curve inversion as a signal has changed at all. Every slowdown and every cycle is a little different so how it plays out is a little different. But that signal is just as powerful and accurate as ever. I think the economy is going to slow meaningfully in the second half of this year, but not fall into recession until 2024.” Facet has been overweight on healthcare and established technology companies with higher profit margins, lower debt levels 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 Senate lawmakers repeatedly asked him on Tuesday whether interest rates are the only tool available to policy makers for controlling inflation. Powell replied that interest rates are the main tool, demurring from an opportunity to discuss the Fed’s quantitative tightening process — or shrinking of the central bank’s $8.34 trillion balance sheet — in more detail.
QT was once seen as a supplement to rate increases, with one economist at the Fed’s Atlanta branch estimating that a $2.2 trillion passive roll-off of nominal Treasury securities over three years would be equivalent to a 74-basis-point rate hike during turbulent times.
But tinkering with QT now and accelerating the pace of that process would be a “can of worms the Fed doesn’t really want to open,” said Marios Hadjikyriacos, senior investment analyst at Cyprus-based multiasset brokerage XM. That would “drain excess liquidity out of the system and tighten financial conditions faster, helping to transmit the stance of monetary more effectively, but the scars of the ‘taper tantrum’ and the 2019 repo crisis have made Fed officials wary of deploying this tool in an active manner.”
See: The secret to stocks’ success so far in 2023? An unexpected $1 trillion liquidity boost by central banks.
According to Facet’s Graff, last year’s bond-market crisis in England — when a surprising large package of tax cuts from the U.K. government triggered tumult and led to an emergency intervention by the Bank of England — may also be playing a factor in the Fed’s thinking.
“If the Fed got too aggressive with QT, it might have unpredictable outcomes,” 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, honestly, right or wrong.”
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