The normally reliable US bond market is sending conflicting signals at the moment, adding to the confusion about whether the economy is currently in a recession, heading into a recession, or will achieve a soft landing and avoid a recession. High quality bonds continue to send warning signals, with the Treasury yield curve inverting further in recent weeks. The difference between 10-year and 2-year treasuries has fallen to -35 basis points (bps) as of last week, the deepest inversion since the turn of the millennium (red line on the first chart below). Another measure of the yield curve which compares 10-year yields to the overnight rate that the Fed directly controls has plunged to just 39 bps, a sharp reversal lower thanks to the Fed super-sizing the last two rate hikes (blue line). While it remains positive for now, if the Fed hikes by another 50-75 bps in September than it most certainly will invert too and recession fears will only grow louder.
While that seems ominous, it is not being confirmed by riskier parts of the bond market which have seen notable improvement recently. Over the past month, high yield corporate bond spreads have narrowed by about 150 bps indicating less stress and less risk of imminent default by the lowest-rated corporate borrowers. If the bond market was truly worried about an oncoming recession, then these spreads would be soaring higher just like they were during the worst of the pandemic. Instead, they topped out in early July just slightly above the level reached in late 2018/early 2019, which was the last time there were concerns about a Fed policy mistake from hiking rates too much. Back then, once the Fed changed tack markets recovered swiftly throughout 2019. While we don’t know if there will be a repeat of that, as long as the riskiest corporations can continue to access the bond market then the odds of a credit crunch and widespread defaults go way down.
So which part of the bond market will prove to be right? Let’s see what the Fed does this fall as more signs of demand destruction appear. A pause in their hiking cycle sometime over the next few months would go long way towards boosting the odds of a more benign outcome – and possibly even the elusive soft landing.
Carl Noble, CFA®
Senior Vice President of Investments
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