One of the bond market’s most popular indicators of the approaching US recessions has the potential to post its most negative readings since the early 1980s reign of former Fed Chairman Paul Volcker.
This is the view of a team from BNP Paribas, who say that the spread between 2-TMUBMUSD02Y,
and the 10-year Treasury yields TMUBMUSD10Y,
could reach around minus 130 basis points if the Fed ends its rate hike cycle with a fed funds rate target of 4.75%.
The spread could even reverse beyond minus 150 basis points if the final federal funds rate is above 5%, they said. That compares to Tuesday’s minus 34 basis points level. The 2s10 spread turns negative, or inverted, when the yield on the 2-year note exceeds the 10-year rate, signaling a deteriorating economic outlook.
The Fed’s commitment to keeping rates in restrictive territory in the face of a recession is what makes the extreme reversal scenario “plausible”, based on analysis of the spread since the 1970s, according to BNP economist Carl Riccadonna, as well as strategists Calvin Tse and Timothée High. The 2-10 year spread – which has a reliable track record of predicting economic downturns, albeit with a lag – turned negative for the first time this year in April, before dropping further below zero over the course of the summer.
“Can the curve still be reversed? We believe so,” the BNP team wrote in a note. “Much deeper reversals were seen when the Fed last fought extremely high inflation. Indeed, the most inverted curve in the past 50 years was in March 1980 at -241 bps.
Financial market participants are increasingly coming to the conclusion that persistent inflation can produce an era of higher rates, for longer, around the world. Under Volcker, the Fed pushed interest rates up to 20% in order to curb inflation.
“To be clear, we are not necessarily anticipating another 75-100bp reversal of 2s10 reversal,” the BNP team wrote. “Other factors such as the domestic fiscal impulse, global tightening, rising foreign bond yields from extremely depressed levels and the Fed’s QT [quantitative tightening] can contribute to the level of the UST 2s10s curve. Still, “in addition to the quantitative arguments, we believe there are fundamental arguments that suggest a very deep curve reversal is possible this cycle.”
The first is that short-term yields will be hard pressed to fall in the near term, given that the Fed “will likely be prevented from pivoting quickly to accommodation amid the first signs of labor deterioration or outright recession. Meanwhile, “longer-term yields could instead serve as a ‘pressure relief valve’ to gauge economic slowdown (or potential recession).”
On Tuesday, traders and investors continued to adjust to the likelihood of higher US interest rates for longer sending the 10-year yield toward 4%, a level not seen on an intraday basis since April 5. 2010. The 10-year rate has not finished at or above 4% during the New York session since October 15, 2008, according to Tradeweb.
Meanwhile, an early rebound in stocks faded by midday, with the Dow Jones Industrial Average DJIA,
and the S&P 500 SPX,
ending lower for a sixth straight day on recession jitters. The Nasdaq Composite COMP,
made a slight gain.
One of the bond market’s most popular indicators of the approaching US recessions has the potential to post its most negative readings since the early 1980s reign of former Fed Chairman Paul Volcker.
This is the view of a team from BNP Paribas, who say that the spread between 2-TMUBMUSD02Y,
and the 10-year Treasury yields TMUBMUSD10Y,
could reach around minus 130 basis points if the Fed ends its rate hike cycle with a fed funds rate target of 4.75%.
The spread could even reverse beyond minus 150 basis points if the final federal funds rate is above 5%, they said. That compares to Tuesday’s minus 34 basis points level. The 2s10 spread turns negative, or inverted, when the yield on the 2-year note exceeds the 10-year rate, signaling a deteriorating economic outlook.
The Fed’s commitment to keeping rates in restrictive territory in the face of a recession is what makes the extreme reversal scenario “plausible”, based on analysis of the spread since the 1970s, according to BNP economist Carl Riccadonna, as well as strategists Calvin Tse and Timothée High. The 2-10 year spread – which has a reliable track record of predicting economic downturns, albeit with a lag – turned negative for the first time this year in April, before dropping further below zero over the course of the summer.
“Can the curve still be reversed? We believe so,” the BNP team wrote in a note. “Much deeper reversals were seen when the Fed last fought extremely high inflation. Indeed, the most inverted curve in the past 50 years was in March 1980 at -241 bps.
Financial market participants are increasingly coming to the conclusion that persistent inflation can produce an era of higher rates, for longer, around the world. Under Volcker, the Fed pushed interest rates up to 20% in order to curb inflation.
“To be clear, we are not necessarily anticipating another 75-100bp reversal of 2s10 reversal,” the BNP team wrote. “Other factors such as the domestic fiscal impulse, global tightening, rising foreign bond yields from extremely depressed levels and the Fed’s QT [quantitative tightening] can contribute to the level of the UST 2s10s curve. Still, “in addition to the quantitative arguments, we believe there are fundamental arguments that suggest a very deep curve reversal is possible this cycle.”
The first is that short-term yields will be hard pressed to fall in the near term, given that the Fed “will likely be prevented from pivoting quickly to accommodation amid the first signs of labor deterioration or outright recession. Meanwhile, “longer-term yields could instead serve as a ‘pressure relief valve’ to gauge economic slowdown (or potential recession).”
On Tuesday, traders and investors continued to adjust to the likelihood of higher US interest rates for longer sending the 10-year yield toward 4%, a level not seen on an intraday basis since April 5. 2010. The 10-year rate has not finished at or above 4% during the New York session since October 15, 2008, according to Tradeweb.
Meanwhile, an early rebound in stocks faded by midday, with the Dow Jones Industrial Average DJIA,
and the S&P 500 SPX,
ending lower for a sixth straight day on recession jitters. The Nasdaq Composite COMP,
made a slight gain.