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Bond market turmoil and inverted yield curve are harbingers of grim times


Natale Labia writes on the economy and finance. Partner and chief economist of a global investment firm, he writes in his personal capacity. MBA from Università Bocconi. Supports Juventus.

These are terrifying times in the bond market. The recent moves in benchmark US treasuries, which ultimately underpin financial markets, acting as the risk-free discount rate of all securities, have been brutal. Where yields go from here is simply the most critical question that investors should be asking.

After hovering around 1.5% for much of last year, the critical 10-year treasury benchmark bond has subsequently sold off (bond yields move inversely to prices) to reach levels last seen pre-pandemic. Having smashed through the psychologically important 2% level, lending to the US government for 10 years will now earn investors 2.33%, almost  2% more than its nadir in mid-2020. Indeed, the last time yields were so high was in mid-2019. Treasuries have had their worst week since 2016.

Chair of the Board of Governors of the Federal Reserve Jerome Powell seems determined to go full Paul Volcker (his monetarist predecessor who brought the stagflationary 1970s to a close with aggressive interest rate hikes in the early 1980s). Doubling down on his intention to raise rates throughout 2022 and into 2023, he even stated this week that he would be open to a 50 basis points hike, a statement that spooked bond markets into their most recent bout of fire selling.

Of course, the relationship between bond markets and the federal funds rate is far more complex than central bankers would want us to believe. It seems like a lot more is scaring fixed-income markets than merely the utterings emanating from deep inside the Federal Reserve.

The misgivings that investors have regarding the future trajectory of the US and global economy seem to be more critical. Regular bond watchers are concerned about the shape of the yield curve, in particular the 2y10y spread (simply put, the difference between the short and long end of the curve). This critical indicator is currently barrelling towards zero.

This is famously the most accurate predictor of recessions. With a success rate of almost 100%, an inverted yield curve, or negative 2y10y spread, has had an almost unerring ability to predict when a recession or at least marked economic slowdown is about to happen.

The last time it inverted was six months before the brutal Covid-19 recession, and before that briefly before the collapse of Lehman Brothers and the financial crisis.

In the past 40 years, whenever this spread has gone negative a recession has transpired.

The reasons are impossible to know, but there are many hypotheses. An inverted yield curve in itself is not negative for the economy or a cause of a recession, but it is indicative of worse economic climes to come.

Essentially, the only reason you would buy a long bond at a lower yield than a short one is if you thought longer yields were going to fall and shorter yields were going to rise.

A reason one might think this was going to happen is if the Fed was having to hike rates more aggressively than expected in the short term, in effect creating a recession, which would lead to lower interest rates in the medium to long term.

That is the classic Fed mistake, which the market seems to be pre-empting Powell into making. Similarly, the reality is that after emerging from the Covid-19 pandemic, the economy in the US seems to have only one way to go, and that is down. Already at full employment and having built up the inventories that were run down during the pandemic and post-lockdown splurge, an inventory-based recession seems a distinct possibility. With only 3.8% unemployed in the US, it is simply not possible to produce more goods or create more growth.

Further to this are the severe risks to the US housing market. In an interview with the Financial Times, the founder of bond investing powerhouse Pimco and self-styled “Bond King” Bill Gross said that he didn’t believe the Fed could raise rates as much as they should. “I suspect you can’t get above 2.5% or 3% before you crack the economy again. We’ve gotten used to lower and lower interest rates and anything else will break the housing market,” he said.

The impact on the US housing market is already evident. Limited stock and a demand rush after Covid-19 have resulted in skyrocketing US housing prices, with affordability hitting lows not seen since before the financial crisis. Now, with rising rates, mortgage rates are at levels not seen for decades, up 28% in the last 12 months. This double whammy is resulting in new home sales dropping about 7% in the last month, according to Bloomberg.

A sustained drop in housing sales will have a profound impact on GDP figures. Housing is a critical part of the US economic motor.

The nightmare situation is one where the Fed creates some kind of inverse Goldilocks situation, where interest rates are high enough to hurt growth through the housing market but too low to get inflation under control. For now, the bond market seems to be pricing that in. While this is not a certainty, and US growth fundamentals could pull through and avert a recession, it is unlikely the bond market is wrong.

Market participants will recall that every time the 10y2y goes negative, bulls are ready to present a long list of why “this time is different” and an inverted curve has a limited correlation to an impending recession. However, we all know what has always subsequently transpired. DM168

This story first appeared in our weekly Daily Maverick 168 newspaper which is available for R25 at Pick n Pay, Exclusive Books and airport bookstores. For your nearest stockist, please click here.


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