The danger sign that has the world on edge

For more than a year the US yield curve has been inverted but the recession the inversion is supposed to signal has yet to emerge. That doesn’t, of course, mean that it won’t.

For more than half a century recessions have followed inversions of the yield curve, where the yields on shorter dated Treasury bills and notes are higher than those on longer dated bonds. Not every inversion has been followed by a recession but every recession has been preceded by one.

The inversion curve is signalling to investors and the wider economy that there are better returns available from taking less risk.
The inversion curve is signalling to investors and the wider economy that there are better returns available from taking less risk.Credit: AP

Currently, the yield on US three-month securities is 5.29 per cent, the 12-month is 4.87 per cent, the two-year is 4.48 per cent and the 10-year is 4.18 per cent.

That’s an inversion of the norm, where duration normally equates to an increased risk of holding securities for longer periods – it’s easier to predict what might happen to affect their value over three months or a year or even two than over a decade.

That inversion persists despite strong economic growth, historically low levels of unemployment and a falling inflation rate in the US; a disinflationary trend expected to be confirmed by this week’s US inflation data.

If the signal the bond market is sending is accurate, however, the US economy is destined to slow and recession, this year or next, would be on the cards.

Given the disparity between what the yield curve is predicting and the current state of the US economy one possible explanation is that investors think the Federal Reserve Board may have been too aggressive in raising US interest rates and is now being too cautious is bringing them down.

The Fed, from March 2022, raised the federal funds rate (akin to the Reserve Bank’s cash rate) 11 times, effectively from zero to the current range of 5.25 to 5.5 per cent.

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That, along with the Fed’s quantitative tightening – allowing $US95 billion ($146 billion) a month of bonds and mortgages it bought during the pandemic to mature without reinvesting the proceeds and keeping pressure on rates and tightening liquidity in the process – represents one of the most aggressive tightenings of monetary policy in America’s post-war history.

Since its last rate hike in July last year the Fed has sat on its hands, leaving its federal funds rate target unchanged even as the US inflation rate, which peaked at 9.1 per cent in June 2022, has fallen steadily back towards its target – it might even be below it now – of two per cent.

Late last year the futures markets were pricing in at least five and as many as seven 25 basis point interest rate cuts this year, starting in March, even as the members of the Fed’s Open Market Committee (FOMC), which makes monetary policy decisions, projected only three.

After last month’s FOMC meeting, which left rates unchanged and where Fed chair Jerome Powell effectively hosed down the prospect of a March cut, investors’ expectations of the first cut in a new cycle shifted to May.

While sharemarket investors remain uber-bullish – the S&P 500 climbed through 5000 points last week, posting another record before edging down on Monday (US time) ahead of Tuesday’s inflation data – bond investors appear more cautious.

The Fed wants to see a widespread fall in inflation across the economy.
The Fed wants to see a widespread fall in inflation across the economy. Credit: AP

Yields on two and 10-year securities that were falling ahead of the Fed’s January meeting have since risen by nearly 30 basis points.

They are probably right to seek some extra compensation for the perceived increased risk that the Fed will leave rates elevated for longer than the markets had expected.

Recent commentary from several Fed board members has indicated that the Fed is shifting the goal posts.

Where previously they were giving the impression that all it would take to start cutting rates would be a core inflation rate within reach of, and clearly heading towards, its 2 per cent target now they are saying that they want to see, not just the headline rate decline, but signs that inflation is falling across the economy.

So far, the driver of the declining inflation has been the falling prices of goods and, to a lesser extent, services. Traditionally “stickier” prices, like housing-related costs, have been falling more slowly – it takes time for changes in rents, for instance, to flow through.

Given the excess capacity within China’s manufacturing base, the relatively smooth functioning of global supply chains (that, near-broken by the pandemic, ignited the global bout of excessive inflation) and the tight monetary policies in place within all the major Western economies, inflation rates should keep falling.

The risk for economies is that, nervous about moving too early in cutting rates and subsequently being forced to reverse course and start a new hiking cycle, central banks will dither and leave monetary policies too tight for too long and precipitate otherwise avoidable economic slowdowns and even recessions.

That risk has been latent in the pricing of the bond market for nearly 18 months and, after the disappointment that flowed from the FOMC’s January meeting, remains priced in.

There is a self-fulfilling aspect to inverted yield curves.

Federal Reserve chairman Jerome Powell has tempered expectations about an interest rate cut in the near term.
Federal Reserve chairman Jerome Powell has tempered expectations about an interest rate cut in the near term.Credit: AP

What the curve is signalling to investors and the wider economy is that there are better returns available from taking less risk.

The bond market isn’t the economy – it has its own supply and demand dynamics – but an inverted curve can be interpreted as a forewarning of a slowdown which in itself could cause businesses and consumers to become more risk-averse.

Lenders also respond to what’s happening in bond markets. If they can generate better risk-free returns than the risk-adjusted returns from making loans, backed by the expensive capital required by regulators, why wouldn’t they buy short-term notes and bonds rather than boost their lending?

There are, therefore, both causes and effects of an inverted yield curve.

As we’re experiencing here, interest rates held high (relative to those that have prevailed for most of the period since the 2008 financial crisis) are imposing significant pressure on household finances. Bankruptcies are increasing. Commercial property values fall when rates rise, with office properties under additional and significant pressure from the post-pandemic changes to the way people work.

If the signal the bond market is sending is accurate, the US economy is destined to slow and recession, this year or next, would be on the cards.

In the US, with Bloomberg reporting Mortgage Bankers Association data that estimates nearly 20 per cent of the outstanding debt on commercial and multifamily (apartment) properties – about $US929 billion of the $US4.7 trillion commercial real estate market – will mature this year, a Fed misjudgment on the timing and rate of any rate cuts could have severe and quite unpleasant consequences.

The risks of moving too late to start reducing interest rates – for the economy, as opposed to the Fed or other central banks’ credibility – are arguably greater than if the banks move too early.

Recessions have ugly impacts on households and businesses and the central bankers do have the ability to lower rates at a pace that minimises the risks of doing too much too soon and reigniting inflation rates.

What happens over the next three or four months in the US – what the Fed does or doesn’t do – will determine whether the signal being sent by the continuing inversion of the yield curve is false or, as it has been in the past, eerily predictive.

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Source: Thanks smh.com