July 12, 2024

The Surprising Message from the Bond Market: Is a Soft Landing Ahead?

Image Credits: Bloomberg

The United States bond market has been buzzing with recession alarms for a record-breaking 212 consecutive trading days, setting a historic precedent dating back to at least the 1960s. Despite this unceasing cautionary signal, optimism is palpable on Wall Street and Washington, with many believing that the U.S. Federal Reserve is skillfully steering the economy toward a gentle landing.

But what’s the story behind this stark contrast between the bond market’s warnings and the economy’s resilience? It all began when the yield curve inverted in October, triggering predictions of an impending recession by the end of this year. However, the U.S. economy has stubbornly continued to expand, defying expectations. A widely-tracked indicator from the Federal Reserve Bank of Atlanta suggests that the economy is gaining momentum.

“This economic cycle has been unusual,” remarks Phillip Wool, Head of Research at Rayliant Global Advisors Ltd. “When the yield curve first inverted, most experts anticipated an imminent downturn. However, the unexpectedly robust performance of the U.S. economy now makes the prospect of a soft landing more promising, though far from guaranteed.”

An inverted yield curve is typically a harbinger of a slowdown, signaling expectations that the central bank will lower interest rates to stimulate growth. Yet, the massive scale of the Fed’s tightening measures, with a more than five-percentage-point increase in its benchmark short-term rate, complicates the picture. This tightening may lead the Fed to ease next year, not necessarily to avert a recession, but to respond to more extraordinary inflation—a scenario some economists have humorously dubbed the “Nirvana scenario.”

The futures market, however, anticipates the Fed’s benchmark rate to hover around 4.4 percent by the end of 2024, significantly above the 2.5 percent considered neutral for growth. During recessions, central banks typically cut rates below this neutral level. Despite these expectations, the inverted yield curve can become a self-fulfilling prophecy, as businesses and consumers may curtail their activities in response to its predictive power.

Moreover, the yield curve has historically inverted well before actual contractions. For instance, in July 2006, the 10-year yield began consistently trading below the three-month rate, but the recession kicked in in December 2007. By then, the Fed had started cutting rates, and long-term bond yields had risen above short-term ones.

Campbell Harvey, the economist from Duke University renowned for using the yield curve as a recession indicator, believes its predictive power remains intact. Instead of focusing on consecutive days of inversion, he looks at the average level over months, suggesting that the current period is shorter. Harvey emphasizes, “Inverted yield curves have accurately forecasted eight of the last eight recessions—ignoring this signal comes at your own risk.”

As uncertainty continues to swirl around the bond market’s persistent recession warnings and the economy’s unexpected strength, investors and policymakers are watching closely, hoping the yield curve’s message may guide them to a soft landing for the U.S. economy.

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