One of the bond market’s most popular indicators of approaching U.S. recessions has the potential to post one of its most negative readings since the early 1980s reign of former Fed Chairman Paul Volcker.
That’s the view of a team at BNP Paribas, which says that the spread between 2-
and 10-year Treasury yields
could get to around minus 130 basis points if the Fed ends its rate-hike cycle with a 4.75% fed-funds rate target. The spread is negative, or inverted, if the yield on the 2-year note surpasses the 10-year yield.
The spread could even invert beyond minus 150 basis points if the terminal fed-funds rate is above 5%, they said. That compares with Tuesday’s level of minus 35 basis points.
The Fed’s commitment to holding rates in restrictive territory in the face of a recession is what makes the scenario of extreme inversion “plausible,” based on an analysis of the spread since the 1970s, according to BNP economist Carl Riccadonna, plus strategists Calvin Tse and Timothy High. The 2s10s spread — which has a reliable track record of predicting economic downturns, albeit with a lag — first turned negative this year in April, before going further below zero over the summer.
“Can the curve invert further? We think yes,” the BNP team wrote in a note. “Far deeper inversions were witnessed when the Fed was last fighting exceedingly high inflation. Indeed, the most inverted the curve got in the last 50 years was in March 1980 at −241bp.”
Financial market participants are increasingly coming around to the idea that persistent inflation may produce an era of higher-rates-for-longer around the world. Under Volcker, the Fed pushed interest rates to as high as 20% in order to break the back of inflation.
“To be clear, we are not necessarily forecasting another 75–100bp of 2s10s inversion,” the BNP team wrote. “Other factors such as the domestic fiscal impulse, global tightening, overseas bond yields rising from extremely depressed levels, and Fed QT [quantitative tightening] can contribute to the level of the 2s10s UST curve.” Still, “in addition to the quantitative arguments, we believe there are fundamental ones that suggest a very deep curve inversion is possible this cycle.”
One is that short-end yields will have a challenging time falling in the near term, considering the Fed will likely “be boxed out of quickly pivoting toward accommodation amid early signs of labor deterioration or outright recession.” Meanwhile, “longer-end yields could instead serve as the ‘release valve’ to price the economic slowdown (or potential recession).”
On Tuesday, traders and investors continued to adjust to the likelihood of higher-for-longer U.S. interest rates by sending the 10-year yield toward 4%, a level not seen on an intraday basis since April 5, 2010. The 10-year rate hasn’t finished at or above 4% during the New York session since Oct. 15, 2008, according to Tradeweb.
An early bounce by stocks faded at midday, with the Dow Jones Industrial Average
down 90 points, or 0.3%, while the S&P 500
edged own 0.2%. The Dow slipped into a bear market Monday, joining the S&P 500.