Do the Bond Markets Predict Recession?

Jun 13 2022 | 2 min

After a decade of relative stability at around 2%, inflation is back in the headlines, reaching a 41-year high of 8.5% in March this year.

 Several factors have caused this sudden spike. One is the surge in demand with the return to normalcy following the pandemic lockdowns, while the labor market has not yet caught up. Meanwhile, global supply chains have been disrupted by the conflict in Ukraine.

 As the conversation turns to recession, what does past data tell us ?

Using Interest Rates to Fight Inflation

Central banks, like the Federal Reserve (the “Fed”), use interest rates to manage the economic cycle.

 When economic growth slows, lower interest rates stimulate demand by making borrowing cheaper. When the economy is overheating (i.e. demand grows faster than supply, causing inflation), higher interest rates dampen demand and counteract inflationary pressures.

 When the pandemic reduced demand drastically, the Fed dropped interest rates to near zero in March 2020. With inflation rising rapidly, the Fed raised interest rates twice this year, and more hikes are expected.

 A Changed World According To WIRP Source: Bloomberg

Anticipating a series of rate increases through the rest of the year, the futures market is indicating an interest rate of 3% by year end. 

Most Likely Fed Funds Rate Path Through March 2023 Based on Futures PricingWhat do Bond Yields Tell Us?

The bond markets usually reflect investor expectations about the economy.

 Investors expect higher returns for longer periods, so the yields are normally higher for long-term bonds than short-term bonds. The difference between short- and long-term yields is called the “spread.” Occasionally, the yields for short-term bonds rise above long-term ones, causing an “inversion” in the yield curve.

 The chart below shows the points of inversion in the yield curve, when the spread between short- and long-term bonds became negative (below the red dotted line). In each case, an economic contraction followed (the shaded area).Gulp.Source: Bloomberg 

Why does this happen?

 When investors predict problems with the economy (e.g. expect a recession), they tend to buy long-term bonds as a safer investment. This increases the price of long-term bonds.

 When bond prices rise, their yield drops. Eventually, the yield of long-term bonds drops below that of short-term bonds, creating a temporary inversion, or negative spread.

What Is Happening Now?

On March 22, five-year Treasury yields were temporarily above those of 30-year Treasury yields (2.6361% vs 2.6004%). The last time this happened (in 2006), the Credit Crunch and the Global Financial Crisis followed in 2007 and 2008, respectively.

 However, the most watched indicator of recession is the spread between two-year and 10-year Treasury yields. On April 1, the yield curve inverted briefly, as the chart below visualizes. US 10 Year Treasury Yield less 2 Year YieldSource: Bloomberg 

Conclusion

The markets simply reflect the consensus of likely scenarios, assuming no major interventions or change, but they are not a crystal ball. While the market indicates that a recession is possible, nothing is certain.

 The strong action of the Fed on interest rates may well succeed in offsetting inflation. This would achieve a “soft landing” for the US economy, cooling it down rather than triggering a recession.

 Past data is helpful, but the previous correlation between events may not recur in a constantly changing world. Every crisis is unique and brings unprecedented opportunities.

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