Extreme inversion leading to recession?

US government bond investors pushed two-year yields above 10-year yields by the widest margin since the early 1980s, a sign of flagging confidence in the economy’s ability to withstand additional Federal Reserve interest-rate hikes.

The classic bond-market barometer of economic health - the yield curve – is still blaring a recession signal, but it may no longer be a reliable metric, according to Goldman Sachs. The widely followed indicator is near its most inverted level - meaning it's deviating from what's considered normal - in over 40 years, and such anomalies are typically taken by economists as a sign that a severe economic downturn is on the way.

But this time round, that doesn't seem to hold true, Goldman said in a research note published on Wednesday 2/9/2023. Instead, the curve inversion may have been caused by low inflation-adjusted interest rates, suggests that a large part of the inversion seen in current US yield curves comes not from high recession odds or inflation normalization.

The US bond curve, as represented by the difference between 2-year and 10-year yields, is near its most upside-down level in over four decades. Its inversion deepened in 2023 despite growing optimism that the US economy is robust enough to stave off a recession. Current levels of inversion across various curve segments all suggest fairly high odds of recession. Yet even as the growth outlook improves – Goldman’s economists recently lowered their recession odds because the financial market has failed to realize that the US economy is strong enough to endure higher inflation-adjusted interest rates for a sustained period. 

The Federal Reserve raised the cost of borrowing from near-zero to around 4.5% last year in a bid to crush soaring inflation. Sharp increases in interest rates would usually be expected to hurt the economy. But various indicators – like the US adding a better-than-expected 517,000 payrolls last month – suggest there hasn't been much of a slowdown in growth.

So it's likely that fixed income investors' assumptions about the equilibrium level of interest rates is out-of-whack, according to Goldman Sachs. Also, the bond pricing performance year to date also indicates that US economy will be in soft landing. However, it will all depend on the inflation risk in US. 

As for Personal Consumption Expenditures PCE, although the overall and core data continued to show a year-on-year decline, investors should pay attention to the fact that the overall PCE recorded a month-on-month increase of 0.3%, compared with a 0.2% increase in November, showing that the upward trend has accelerated. Furthermore, although the core index of the consumer price index (CPI) fell back to 5.7% at the end of last year, compared with the level of 6% at the beginning of last year, the index has only narrowed by 0.3% with the past year have been several large-scale interest rate hikes by the FED. In this way, does the argument that inflation continues to slow down really hold ?

In addition, the Atlanta Fed's wage growth tracker recorded a 6.1 percent gain in December. In the face of continued strong wage growth trends with a better-than-expected 517,000 payrolls last month, inflation is expected to remain entangled, and the stock market is not optimistic in the near short term.

Historically, the end of the tightening cycle marks the beginning of the curve steepening, i.e. when Fed lowers its rates, thereby driving short rates down faster. To position yourself for this yield curve normalization, speak to your dedicated WRISE Client Advisor now or connect with us at www.wrise.com.