The bond market indicates that the Fed remains firm in the fight against inflation

The gap between short- and long-term borrowing costs in the United States has reached its widest point since 1981, a sign that investors expect the Federal Reserve to stay the course in its battle to rein in inflation, even as fears of recession increase.

The two-year Treasury yield traded at 4.2% on Wednesday, while the 10-year yield stood at 3.4%, bringing the difference between the two to 0.84 percentage points. The pattern, known as the “inversion” of the yield curve, has preceded every US economic downturn in the past 50 years.

The deepening of the reversal comes after a report last week showed the US economy continued to add jobs at a healthy pace in November and a major survey indicating that activity in the broad services sector continues to grow. rapidly.

As the data paints an optimistic picture of the state of the economy, some investors fear it could also encourage the Fed to continue to hike interest rates next year, after pushing them up from close range. from zero to a range of 3.75 to 4%. far into 2022. Rising borrowing costs, in turn, are expected to increase pressure on the economy and potentially trigger a recession.

“The market had bet that the Fed would be forced to slow down. The past year has taught us that the market has been wrong about that assumption time and time again,” said Edward Al-Hussainy, principal analyst at Columbia Threadneedle.

The changes in the US bond market also show that investors are more aligned with what the Fed has announced for the coming year. Although the yield curve has been flattening all year, it rebounded in late November and investors last week began pricing in two interest rate cuts by the end of 2023, both pointing to an easing in monetary policy.

This gap between the Fed and the market was particularly evident after a speech by Chairman Jay Powell last week in which he signaled that while the US central bank would slow its pace of rate hikes at its December meeting, it would. to allow rates to stay higher for longer. The markets focused on the first coin and not the second.

After Friday’s US jobs report, however, the steepening of the yield curve slumped, although rate cuts next year are still factored in. Futures markets are currently suggesting the “terminal” federal funds rate, or the peak of this cycle. , will be around 5% in May, compared to expectations as low as 4% in September.

“The [November] The payrolls report reminded us that the labor market remains in very good shape, and we expect this to be reflected in a higher terminal rate in the points,” said Ben Jeffery, US rate strategist. at BMO Capital Markets, referring to the Fed’s Quarterly Survey of Officials on Economic and Monetary Policy Developments in the Years Ahead – also known as the “dot plot”. The next dot chart will be released at the December Fed meeting.

The most fundamental signal sent by the inverted yield curve is that investors believe that the Fed’s short-term rate hikes will be successful in bringing inflation down sharply. The magnitude of this reversal then reflects both the dramatic pace of rate hikes and the fact that the Fed has maintained that pace even as investors have changed their inflation and growth expectations.

“We think the shape of the yield curve is a measure of how much monetary policy can tighten, and the market clearly thinks the tightening is going to persist for some time,” said Mark Cabana, head of the US rates strategy at the Bank. from America.

Credit Suisse’s Jonathan Cohn added that the steepening of the yield curve inversion suggests to investors that the Fed is committed to “moderate inflation even if it has to sacrifice forward-looking growth or recession.”

In a survey conducted in December by the University of Chicago Booth School of Business’s Initiative on Global Markets in partnership with the Financial Times, 85% of economists said they expected the National Bureau of Economic Research – the arbiter of the US recession – will declare one by next year.

Although the yield curve has been a reliable indicator of the recession, the information conveyed by the depth and extent of the inversion is open to debate.

“The inverted yield curve is actually a pretty good signal of a recession, without providing any insight into its depth or severity,” said Guy LeBas, chief fixed income strategist at Janney Montgomery Scott.

“In this case, the reversal probably tells us more about inflation and the direction of inflation risks than it does about the depth or severity of a recession.”

While strategists such as LeBas argue that the degree of yield curve inversion may not directly predict the depth of the coming recession, the current deepening could have wider ramifications if it leads to changes in investor behavior.

“The most important aspect of the yield curve is what it does to risk taking,” said Gregory Peters, co-chief investment officer for fixed income at PGIM. “It’s a self-reinforcing mechanism.”