Recession Warnings From The Bond Market Have Intensified

It seems that bond markets are sending out a more urgent recession warning, as well as signaling that the Federal Reserve may be forced to pause raising interest rates, giving up its battle against inflation as a result.

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Silicon Valley Bank's failure and fears about broader contagion shook the bond market and sent rates plunging in the wake of the failure. Since Wednesday, the yield on the 2-year Treasury note has fallen by about 100 basis points, its biggest move in three days since the stock market crash in October 1987. In percentage terms, a basis point is equal to 0.01 of a percentage point.

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Moreover, the steepening of the yield curve was caused by the sharp move in the 2-year yield. During a volatile flight-to-safety trade, investors rushed to buy bonds as bond yields fell when bond prices rose.

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Since the 2-year-to-10-year yield curve has been inverted for quite some time, this means that the yield on two-year bonds is higher than the yield on ten-year bonds. There are some economists who believe that this inversion is an indication that the economy could be heading toward a recession. On Wednesday, the spread between both rates reached its widest level since 1981 when it reached 111 basis points. There was a 47 basis point narrowing of the spread on Monday.

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According to Peter Boockvar, a chief investment officer of Bleakley Financial Group, the deep inversion has been signaling a recession for the past several months. “There is always a steepening of the market at the start of a recession because the market expects the Fed to cut interest rates in response to that recession.”

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There was a yield of 4.01% on the 2-year Treasury note Monday afternoon, while the benchmark 10-year Treasury note yield was at 3.54%. In terms of Fed policy, the 2-year is the most closely related to it, and the Fed funds futures also moved in parallel. The odds of a quarter-point rate hike next week have gone from 100% last week to about 64% on Monday, Boockvar said. It is also believed that the market has begun to price in 75 basis points of rate cuts for the rest of this year.

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“After the steepening of 2s/10s, the ‘Countdown to recession’ averages 9 months to commence,” wrote Julian Emanuel, head of equity, derivative, and quantitative strategy at Evercore ISI.

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It is also believed that the aggressive steepening of the Treasury yield curve after inversion indicates imminent recession, according to DoubleLine Capital CEO Jeffrey Gundlach. Gundlach previously stated that the yield curve started steepening before the past four economic downturns.

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Gundlach said the steepening of the spread is a sign that a recession is nearing.

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The Nasdaq index rose Monday as traders speculated the Fed would have to change its plans to maintain high-interest rates in the future. There was a slight decline in the S&P 500 index at the close of trading. Emanuel expects the volatile stock market to retest its October lows in the near future. This would be consistent with the onset of a recession in the second half of 2023, which is predicted to occur at the beginning of the next decade.

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In a note published by Evercore ISI chief economist Ed Hyman, he stated that it would be a good idea for the Fed to pause its hikes in response to the financial shock caused by the failure of the banks.

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According to Gundlach, he still expects the Fed to raise the fed funds rate range by a quarter point on March 22 but added that it could be the last hike in the range.

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“This is a serious setback in Jay Powell’s game plan...I think that we are temporarily going to have to abandon the fight against inflation for now,” Powell said on Trade Algo.

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Economists at Goldman Sachs have cut their forecast for the Fed to raise interest rates by a quarter of a point next week. According to NatWest economists, they also do not expect a rate hike to take place anytime soon. Fed funds futures have moved in a dramatic manner over the past few weeks reversing some of the Fed's rate increases.

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In fact, many traders were even pricing in the possibility of a 50 basis-point increase following the comments made by Fed Chair Jerome Powell last week. On Tuesday, Fed Chairman Powell told Congress that, in order to bring inflation under control, the Fed could have to raise rates even more than expected. There was a dramatic rise in interest rates as a result of that. However, on Wednesday, SVB announced that it had lost $1.8 billion in asset sales, which marked the beginning of the end of the company.

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There are plans to safeguard depositors and financial institutions affected by SVB's collapse, which have been approved by the US government Sunday. It is anticipated that customers will be able to access their funds at both SVB and Signature Bank, which was shut down by New York regulators on Sunday.

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NatWest's chief U.S. economist, Kevin Cummins, has been predicting the beginning of a recession in the second half of the year. In his view, the developments surrounding the bank failures make it even more likely that the situation will arise. According to him, such a move could create downside risks due to tighter lending standards and the fallout on consumers and businesses as well. “You could argue that based on that channel, you could also make the case that the growth outlook is weaker as well."

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End of rate hiking cycle?

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Despite high inflation, Cummins said the Fed may have reached the end of its tightening cycle. As the economy slows, inflation could also slow down.

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It is possible that the yield curve could invert as a result of Fed policy keeping longer duration rates lower, said Barry Knapp, managing partner of Ironsides Macroeconomics.

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Nevertheless, he expects the Fed will have to act to ease banking system worries.

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"I think the main issue, in this case, is that there's going to be a monetary response that will have to be undertaken," he said. “I do not believe that they need to cut rates right now, but I do believe that they need to pause for the time being.”

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The volatility in rates was exacerbated by Powell's hawkishness last week. As a result of his remarks, the yield on the 2-year note jumped above 5%.

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“It was like he dropped a torpedo into the water, and he brought up a whale from the water,” said Knapp.

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