There is certainly a lot happening in the financial markets right now. It is more important than ever during times like this to step back and focus on what we do know. And the clearest messenger right now is the bond market.
We have discussed the 10-2-year treasury yield curve a lot over the last year. An inverted yield curve, which means the 10-year treasury yields less than a 2-year treasury, is a great pre-condition to a recession. However, it is the “de-inversion” of the yield curve that signals a recession is close to occurring. In the chart below, and indicated by my horribly drawn black arrows, you can see this “de-inversion” occurred before every recession since 1989. Over the last few days the 10-2 yield curve has moved from -1.10% to just -0.5%, which is the bond market telling us that recession is coming.
Source: Bloomberg as of 3/15/23
Why does this occur? It is because the market starts to price in Federal Reserve rate cuts. With the banking issues that have arisen over the last week, we see a dramatic reversal in the Fed Funds rate expectations. The current Fed Funds target rate is 4.75% but the market now expects that rate to be 3.85% by January of next year, or close to 1% lower due to recession expectations. This leads to a drop in the 2 year treasury rate, which has fallen from 5%+ to just 3.8%, and the de-inversion.
Source: Bloomberg as of 3/15/23
We think the bond market has now officially priced in a recession, sooner rather than later. HY credit remains a key area to continue to avoid.
Sean Dillon, CMT, CFTe
SVP, Investment Strategies
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