Impending Bond Curve Inversion US Recession Alert

The world’s largest bond market is signaling that the risk of a US recession is rising, even before the Federal Reserve raises interest rates.

The Treasury yield curve has collapsed to near inversion, a situation in which short-term rates exceed longer-term rates, which has often preceded a recession.

The development intensified just ahead of next week’s almost certain Fed rate hike, as rising commodity prices raise the risk that inflation will be more persistent than anticipated. The forward markets already show that traders are preparing for 2-year and 10-year rates to reverse within a year.

Investments in the bond market have a long history of being a harbinger of an economic downturn. There is a growing perception that trouble lies ahead, even if many indicators of economic health, such as the falling unemployment rate, suggest a recession is still some way off. However, the Russian invasion of Ukraine could cause a rapid deterioration.

Ed Al Hussainy, senior interest rate strategist at Columbia Threadneedle Investments, said a reversal is imminent, possibly this week.

“We are overdue for a reversal and for a revival of all those suspended talks that a recession is comingAl-Hussainy said. He noted that his company is positioned to benefit if the Treasury curve continues to flatten, adding that Columbia Threadneedle’s long exposure is in the 10- to 30-year area of ​​the Treasury curve. “Bond investors don’t have to wait for a real recession to make money” with flatter bets.

Bets on parts of the curve flattening are the biggest since 2015, according to Citigroup Inc., which tracked two- and 10-year notes in the futures market.

Flattening has been a very profitable trade as the gap between two-year and 10-year cash yields has slumped to around 26 basis points, from about 92 basis points at the start of 2022. That puts the spread almost in the multi-year high of 162 basis points reached in March 2021.

Historically, recessions occur about a year after a reversal occurs, but there is a risk that war will speed things up.

The last time the curve inverted was in 2019, following a series of Fed rate hikes. It was the gap between three-month and 10-year yields—the spread that is the focus of academic research linking the curve with recessions—which fell below the zero line in March 2019, and the two- to 10-year yield gap reversed about five months later. In 2020, the United States was hit by a recession caused by the pandemic.

Few economists, however, see the United States in danger of recession as the economy is supported by a strong labor market, strong consumer spending and better-than-expected corporate earnings. But many expect growth to slow further if inflation continues to rise.

However, it is possible that the legacy of global quantitative easing may be clouding the message from the bond market. With billions in debt purchases distorting prices, some say the curve now needs to invert to about -1% to give a real recession warning.