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What are the bond markets saying?

  • With a jump in headline inflation to another fresh 40-year high in June, the U.S. Federal Reserve is expected to sharply increase interest rates at its meeting this month, raising the odds of the central bank triggering a recession.
  • Against this backdrop, investors are pouring into longer-dated U.S. Treasury bonds, anticipating that these securities will outperform equities and other risk assets if the U.S. slips into a recession.

Bond markets are sounding the alarm on recession as long-dated Treasury yields dip below short-dated ones with the U.S. Federal Reserve in the fight of its life against inflation.

Under normal conditions, U.S. Treasuries that are long-dated, for instance 30-year bonds, would be expected to deliver higher yields than short term instruments like a 2-year note because investors would need to be more heavily compensated for the opportunity cost of their money being locked away for a longer period.

Yield curve inversion occurs when long-dated bonds yield less than short-dated notes because investors believe that the economic outlook is poor, and as such are willing to be paid less because there are no better places to park their money in the future, typically a signal of rising recession expectations.

And that is precisely what is occurring at the moment.

With a jump in headline inflation to another fresh 40-year high in June, the U.S. Federal Reserve is expected to sharply increase interest rates at its meeting this month, raising the odds of the central bank triggering a recession.

If the Fed hikes rates by a full 1% this month, it would mark the biggest increase since the central bank started directly using the overnight rate to conduct monetary policy in the 1990s, raising the risk that already slowing growth will stall with borrowing costs stifling investment and consumption.

Against this backdrop, investors are pouring into longer-dated U.S. Treasury bonds, anticipating that these securities will outperform equities and other risk assets if the U.S. slips into a recession.

In a recession, equity prices and those of other risk assets, can be expected to fall and investors will seek out haven assets, such as Treasuries, sending the prices of such securities increasing which lowers their yield (yields fall when bond prices rise) and increases their price.

Which is why on Wednesday, long-dated Treasuries rallied hard in the wake of U.S. Consumer Price Index data, driving 10-year yields as much as 0.28% lower than 2-year yields, the most since 2000, after the dotcom bubble burst.

The jury is still out on whether the Fed will step in with a super-sized rate hike this month, especially with retail sales and housing data yet to be factored in, and policymakers are divided between a 0.75% hike and a 1% increase in borrowing costs.

Investors will now need to consider if the yield curve’s inversion will be like that of 2000, or the much steeper inversion experienced in the high inflation 1980s, where the Fed’s effort to keep inflation in check sparked off consecutive recessions.

So far, markets appear to be pricing in two 75-basis-point hikes for July and September (there is no Fed meeting in August), but there’s a chance that a persistently inverted yield curve could trigger a fresh credit crisis.

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