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IN THE MARKET: ECONOMIC SURPRISES ARE MESSING WITH THE MARKET'S FAVORITE
RECESSION PREDICTOR

By Paritosh Bansal
April 29, 202411:59 AM GMT+2Updated 3 days ago
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A street sign marks Wall Street outside the New York Stock Exchange (NYSE) in
New York City, where markets roiled after Russia continues to attack Ukraine, in
New York, U.S., February 24, 2022. REUTERS/Caitlin Ochs/File Photo Purchase
Licensing RightsNew Tab, opens new tab
April 29 (Reuters) - A bond market anomaly that has reliably predicted a U.S.
recession in the past may normalize this year in a highly unusual manner. It's a
worry for markets.
The market signal, called a yield curve, has been upside down since early July
2022, with investors getting less to lock up their money for longer periods than
they are for shorter durations. The benchmark U.S. curve shows yields on 2-year
Treasuries are about 30 basis points higher than 10-year bonds.
Advertisement · Scroll to continue

In the past, yield curves typically become right-side up as an economic slowdown
leads the Federal Reserve to cut interest rates, bringing down yields on
near-term bonds that are sensitive to policy rates, a phenomenon called bull
steepening.
This time around, though, it is starting to look like the curve may normalize
because longer-term bond yields would rise in a bear steepening, interviews with
half a dozen investors and other market experts show. That is due to pressure on
longer-term rates from increasing U.S. debt, while a surprisingly robust economy
and sticky inflation keep the Fed from cutting rates.
Advertisement · Scroll to continue

A bear steepening, which briefly reared its head in October, could resume at
some point this year, leading the yield curve back to normal through a rarely
trodden path.
"What we saw in the later stages of 2023 was the beginning of that curve
normalization," said Dan Siluk, a portfolio manager at Janus Henderson. "We'll
get a continuation of that theme through the back end of 2024."
Both the shape of the curve and the reasons for its steepening have important
implications for the real economy and Wall Street. The yield on 10-year Treasury
bonds would have to rise above 5% for the curve to normalize, the investors
estimated, which raises interest costs of businesses and consumers. Inflation
would remain sticky in a bear-steepening scenario.

While a normal yield curve is good for banks, a bear steepening would be hard to
trade and pressure stocks, leading possibly to market swings.
Moreover, the normalization of the curve would not mean the economy had dodged a
recession. Higher long-term rates could make an eventual slowdown more likely,
and a high debt load would hamper the government's ability to respond.
"It's too early to dismiss this as a false signal," said Campbell Harvey, a Duke
University professor who first proposed the inverted yield curve as a recession
indicator. "It is negative that long-term rates go up."
Advertisement · Scroll to continue

Harvey pointed out that the time it takes for a downturn to manifest after
inversion varies, and that in the four most recent inversions the curve turned
positive before a recession started.

Reuters Graphics


INCHING HIGHER

To be sure, a bull steepening could also still happen. High policy rates could
still slow down the economy, weaken the labor market and hurt consumers, leading
the Fed to cut rates. High interest rates could also cause a market ruction,
like a banking crisis, that forces the Fed to lower rates.

But investors said absent that, conditions were building up for a bear
steepening. If growth and inflation persist, it would suggest the long-run
equilibrium interest rate for the economy, called the neutral rate, is higher,
putting pressure on yields. And the immense amount of debt the U.S. government
is taking on would eventually lead investors to charge more for it.
There are some signs of investor worries in markets. A New York Fed model that
breaks down Treasury yields into its components shows the premium investors
charge for lending money over time has been inching up once again.
The term premium had turned positive during the October bear steepening, but
fell into negative territory later that year as the Fed pivoted to guiding the
market on lower rates. It turned positive again this month, most recently on
April 24.
Another indicator of the broader concern: the price of gold and bitcoin.
Pramol Dhawan, head of Pimco's emerging markets portfolio management, attributed
an increase in the price of gold over its fair value due to demand from official
institutions for safe-haven assets.
That would reduce buyers of Treasuries even as supply increases.

Reuters Graphics


HARD TO PREDICT

What is not clear, though, is when these concerns will become front and center
for markets, which are more focused on the Fed rate outlook at the moment.
An event like the UK’s debt crisis of autumn 2022 is hard to predict, although
investors said they were watching for spending plans of both U.S. political
parties as the November election approaches.
BNY Mellon strategist John Velis said they were concerned about the Treasury
Department's August refunding announcement, in which it lays out the borrowing
needs for the quarter. The one before that on May 1 is of less concern as tax
receipts would have lessened the need for funding through the summer.
More likely, a bear steepening would be a slow process with uncertain timing.
That, however, makes it harder for traders.
Bill Campbell, who heads DoubleLine Capital's global sovereign team, said it is
costly to put trades ahead of a bear steepening, so timing becomes important.
That is leading macro hedge funds to go in and out of the trade, Campbell said.
Investors are also looking at other ways, such as using smaller trade sizes.
"You're just trying to find clever ways to put it on," Campbell said. "In the
bear steepening scenario, we think it's going to be more of a grind higher."

Get a look at the day ahead in U.S. and global markets with the Morning Bid U.S.
newsletter. Sign up here.

Reporting by Paritosh Bansal in New York Editing by Matthew Lewis

Our Standards: The Thomson Reuters Trust Principles.New Tab, opens new tab

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Purchase Licensing Rights
Paritosh Bansal

Thomson Reuters

Paritosh oversees the work of more than 100 journalists across the globe who
write about finance and markets, including banking, financial technology,
stocks, bonds, forex, corporate finance, white collar crime and environmental,
social and governance (ESG) investing. He also writes a column, In the Market.
With some 25 years in the profession and degrees in economics, journalism and
physics, Paritosh has reported and edited the news file across the spectrum,
from business and economics to politics and general news.

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