Just in case there is any lingering doubt, the bond market is now pricing in the near certainty of a Federal Reserve-induced recession that is already here or on the way shortly. The three-month Treasury yield now sits some 86 basis points ahead of the 10-year yield, a level not seen since at least the early 1980s. this period. A basis point is one hundredth of a percentage point. In fact, the last time the disparity was so pronounced was when then-Fed Chairman Paul Volcker induced a recession to end the runaway inflation of the 1970s and early 1970s. 1980s. Now some investors fear that current chairman Jerome Powell will do the same. “The last time we were here was at the start of the ‘Volcker Recession’ and his Fed was already cutting rates,” DataTrek Research co-founder Nicholas Colas said in his daily note to clients Tuesday evening. . “Now we have a Fed that’s still talking about ‘higher for longer’ rates, the opposite of the 1981 trajectory. Markets are essentially saying there will soon be another man-made economic contraction: the ‘Powell recession’.” Those fears manifested themselves in a sell-off this week for a market that rallied strongly last week after Powell’s comments were interpreted as dovish. The rally was the latest in a series of miscommunications between the markets and Powell, who has been adamant that the central bank will not back down from policy tightening until there are clearer signs that the inflation is falling. The three-month/10-year Treasury relationship is watched closely in markets for its predictive power, primarily because the former is seen as reflecting the Fed’s near-term policy, while the latter is tied to growth expectations. longer term and what the markets consider. a “neutral” rate level that is neither restrictive nor incentive. The New York Fed even has a tracker on its site that measures the possibility of a recession using the 3-month/10-year curve. At the end of November, the level of inversion implied a 38% probability of recession within 12 months, according to the central bank’s methodology. But as Colas points out, a probability of 38% is as good as 100% according to historical trends: each time the New York Fed indicator exceeds a probability of 30%, a recession ensues. (Recession areas are shaded.) Source: Federal Reserve Bank of New York, The Yield Curve as a Leading Indicator The Fed’s model “clearly indicates that high short-term interest rates will cause a recession over the next 12 months,” Colas wrote. . “Furthermore, these odds are very likely to increase.” That’s at least in part because policymakers plan to keep raising interest rates. Central bank officials have signaled, and markets are widely pricing in, another 0.5 percentage point hike when the Federal Open Market Rate-Setting Committee meets Dec. 13-14. This would bring the benchmark borrowing rate to a range of 4.25% to 4.5%, the highest in 15 years. Markets also expect the Fed to approve a few more increases, eventually bringing the bottom of the range to around 5%. If current momentum persists, it would likely invert the curve further as short-term rates rise and growth expectations decline, exacerbating the likelihood of a recession. Certainly, some key points in recent economic data are not a runaway recession. Nonfarm payrolls rose 263,000 in December, ahead of Wall Street expectations. November’s ISM readings for manufacturing and services showed continued expansion, and even some inflation indicators, such as unit labor costs, declined. But economists expect higher rates to push consumers to spend less. Some high-profile layoff announcements have also raised concerns that companies are bracing for a contraction next year. Most Wall Street firms are expecting a recession, although Goldman Sachs said it still sees the way to a “soft landing” in which the central bank can engineer a pullback in inflation without bringing it down. the economy. Capital Economics predicts the economy will enter a “mild recession” next year, with unemployment reaching around 5% from its current level of 3.7%. “While recent data has been a little stronger than expected, most forward-looking indicators have continued to deteriorate, with our composite tracking models placing the odds of the economy in a recession six months from now at nearly 90%.” , Andrew Hunter, senior US economist at Capital Economics, said in a note on Wednesday. Similarly, Wells Fargo economists noted that “our own yield curve forecasts signal turbulent times ahead, consistent with our expectation of a recession starting next year.” In addition to deciding rates, FOMC members will update their outlook on the funds rate, gross domestic product, inflation and unemployment. Morgan Stanley expects committee members to raise their outlook for the funds rate end point, but point to a “long waiting period.” The company also thinks the Fed will lower its unofficial inflation and GDP forecasts while changing the wording of the post-meeting statement to say it expects “further hikes” in rates ahead, which would give the committee leeway on the number of increases to come. .
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