Investors scrutinize the bond market every day for signs of danger coming down the tracks. And frankly right now, many don't like what they see. Chatter about whether or not the US is headed for a recession is growing louder by the minute. Now before we get too paranoid, let’s get into the facts. This blog is all about the truth and not about opinions. The US Treasury yield curve, a graph that plots the yields of different government bonds, has inverted ahead of every recession since the 1950s. As a result, that has made it the most closely watched growth indicator on Wall Street. The curve has flattened dramatically in recent weeks as markets have ramped up their expectations for the number of interest rate hikes this year, which means yields on shorter-dated debt are catching up to those on longer-dated bonds. And although the curve hasn't inverted yet, some investors think it could do so in the next coming months.
Fed data shows that the gap between the yields on the 2-year and the 10-year Treasury has fallen to around 40 basis points, its smallest since April 2020. Some parts of the curve have already inverted, with the 10-year yield falling below the 7-year yield on Monday. Now Jeffrey Gundlach, the investor often known as the "Bond King", told CNBC last week the US economy could fall into recession in 2022. Jeffrey states, "The yield curve has us on watch already. Once you get the yield between the 10-year Treasury and 2-year Treasury inside of 50 basis points, you're on recession watch. And that's where we are." However, most investors think fears about a recession are overblown, even though countless other media channels continue to promote this fear mongering.
Now in reality only 12% of fund managers around the world are predicting a recession, according to a Bank of America survey released Tuesday, although 30% expect a bear market in which stocks could fall even more than 20%. The yield curve is flattening because investors are expecting the Fed to raise interest rates aggressively in 2022 as it grapples with the strongest inflation in 40 years. In fact, Goldman Sachs is predicting seven rate hikes. The 2-year yield, the most sensitive to Fed interest rate expectations, has shot up from around 0.22% in November to close to 1.6%. If interest rates go up, the fixed returns on bonds become less attractive. That pushes up yields, which move inversely to prices. Longer-dated yields are also rising, but not as quickly. To many investors, this suggests the Fed's rate hikes will lead to slower growth in the future. The way it works is that if growth prospects look good, then investors will want to hold riskier assets such as stocks and so they'll sell bonds, pushing up their yields. But if the outlook is cloudy, investors will want to hold government bonds, which are considered “ultra-safe”, keeping prices higher and yields lower.
According to Seema Shah, chief strategist at Principal Global Investors, "The curve could invert within the year”. However, she said an inversion may not be the reliable signal it once was, because the huge quantities of government bonds now owned by central banks are suppressing long-term yields. Top JPMorgan strategist Marko Kolanovic told clients in a note this week not to worry. Kolanovic states "We think it is wrong to position for a recession given still extremely favorable financing conditions, very strong labor markets, under-leveraged consumers, strong corporate cash flows and banks' strong balance sheets”. Kolanovic said the sell-off in stocks – the S&P 500 is down more than 7% for the year – has gone too far, saying that the economic cycle is "far from over”. After holding interest rates near zero since the start of the pandemic, Fed Chair Jerome Powell and his colleagues are poised to embark on a credit-tightening campaign next month, with some economists forecasting an outsized half percentage-point increase to start the cycle.
The danger is that, with price gains far above its 2% inflation target, the Fed will be pressured into possibly pushing rates too high, thus pushing the economy into a downturn as a result of rapidly raising borrowing costs for consumers and companies. At the same time, fiscal policy also will be acting as a damper on growth. As prices for everything from gasoline to rent have surged, support has waned for President Joe Biden’s push to reshape the economy by strengthening social investments, with his poll numbers continuing to plummet as a result. All in all, despite all these rumors and financial scares going on, my best advice is to block it all out and just plain listen to the facts. Watch the Treasury yield curve. Pay less attention to the propaganda and trust the numbers. Make your own careful judgement about what you believe is going on. And when the time is right, make smart investment decisions with your money.