Bond traders dismiss stock market rally as misguided euphoria

(Bloomberg) – For a moment on Wednesday, so brief that if you blinked you might have missed it, the US Treasury curve reversed to levels not seen since Paul Volcker assaulted the economy with its struggle to break inflation in the early 1980s.

While you should only read part of this fleeting move, the fact that it happened was a stark reminder of just how convinced the bond market has become in its collective belief of an impending economic downturn. , especially in the face of soaring equities and falling volatility in recent weeks.

Since early July, the widely seen spread between 2- and 10-year yields has plunged around 5 basis points to -58 on Wednesday (before ending the session at around -44), a stark contrast to the plus more than 11% rally in the S&P 500 index of US stocks. Moreover, academics, analysts and investors close to the market see little chance of the recent trend of short-term Treasuries giving a premium over longer-term debt – a phenomenon widely seen as a harbinger. economic malaise – will reverse anytime soon.

In fact, as the Federal Reserve continues its efforts to tighten monetary policy, many expect it to deteriorate, and with it the outlook for the economy.

“The inverted yield curve shows that the current path of Fed policy will eventually push the United States into recession,” said Gennadiy Goldberg, senior interest rate strategist at TD Securities, who predicts that the spread between 2- and 10-year yields is about to reach an extreme of -80 basis points. “The longer the inversion continues, the more nervous investors as well as consumers will become about a recession, and that could have almost self-fulfilling consequences.”

Even Wednesday’s weaker-than-expected consumer price reading in July did little to change bond traders’ expectations, in part because Fed leaders were quick to note that the CPI print was not changing. not their view of the central bank’s trajectory to higher rates.

“I’m confident the Fed is going to follow through on the bullish policies they’ve been talking about,” said Greg Whiteley, portfolio manager at DoubleLine Group. “I see higher rates across the curve, especially at the front with more inversion,” he said, adding that “the bond market’s return outlook isn’t exactly rosy right now. It It’s also hard for me to be positive on equities either – I think you’ll see declines in prices of both asset classes.

Of course, the inversion of the curve between 2 and 10 years is still far from corresponding to the levels observed in the Volcker era, when the spread exceeded -240 basis points. It was hovering around -40 basis points early Thursday.

Still, market watchers say the spread doesn’t need to reach such high levels to signal significant pain for the US economy. Moreover, it is not just the 2 to 10 year portion of the curve that is showing warning signs.

The spread between 3-month rates and 10-year yields plunged from 234 basis points in May to around 19 basis points on Thursday – and even briefly fell below zero on August 2.

This is the curve that economist Campbell Harvey focuses on – credited with linking the slope of the yield curve to economic growth in his 1986 dissertation at the University of Chicago.

“Even if the curve is really flat, like it is now, that’s not good news,” said Harvey, a professor at Duke University’s Fuqua School of Business. “Just based on the market and the price moves, it looks to me like we’ll get the full 3-month to 10-year rate reversal. And that’s going to be code red for me.

Read more: Worried about curve inversion? There’s more to come: macro view

For stock market bulls piling into meme stocks, unprofitable tech companies and even SPACs over the past few weeks, this could spell trouble.

Citigroup Inc. strategists, using a mix of spot and forward curves to help build a predictive model, now say there’s a greater than 50% chance of a recession within the next year.

“It’s a perfect storm now with both sides of the curve causing the reversal and making it likely to continue,” said Jason Williams, strategist at the New York-based bank. “Given the strength of the labor market and still high inflation, there is no reason for the Fed to slow its rate hike.”

Transactions in the futures market also show that traders expect the curve to remain inverted for at least another year, albeit less than two, based on data from Bloomberg.

Two-year Treasury yields jumped to over 3.1% from 0.73% at the end of 2021. Long-term yields have not risen as much, with the 10-year duration currently hovering around 2.75%, down from such a high level. to 3.5% in June.

Of course, it’s possible that bond traders collectively are just too pessimistic, and the stock market reading is actually the correct one.

Bill Merz, fixed income director at Minneapolis-based US Bank Wealth Management, doesn’t think so. Investors should brace for below-average forward yields on the S&P 500 and rising unemployment, he said in an interview.

“We are in an environment of slowing economic growth, with aggressive tightening of monetary policy and liquidity globally,” said Merz, whose team tracks various curves to help inform its forecast.

How long and how painful a US recession will last is unclear, but the performance of the Treasury curve and credit spreads signals to some that it won’t be as bad as the 1980s.

“We think there may be something between the disinflation soft landing scenario and a severe recession,” Brian Nick, chief investment strategist at Nuveen, told Bloomberg Television. “The idea that the Fed will pivot and cut rates by March of next year is probably too much to hope for at this point.”

©2022 Bloomberg LP

Leave a Comment

Your email address will not be published.