The Bond Market Gets Less Scary
The yield curve is getting less inverted, mostly for good reasons
By
Justin Lahart, The Wall Street Journal, July 13, 2023
[big snip describing Treasury yield changes]
This all matters because when shorter-term rates are higher than long-term ones the yield curve is said to be inverted, and yield-curve inversions have been good recession forecasters in the past…
For his part, Fed chairman Jerome Powell has highlighted Fed research showing that the difference between the expected three-month interest rate 18 months from now and the current three-month yield — dubbed the near-term forward spread — is where the true predictive power of the yield curve lies…
Of course a less inverted yield curve can be a cause for alarm rather than relief. This is because when the yield curve uninverts it is often because the Fed has begun, or is about to begin, cutting rates sharply in a belated effort to prop up an economy that is plunging into recession.
For now, however, the narrowing inversion seems to reflect an expectation that the Fed will soon stop raising rates because inflation has begun to cool and that it will lower them only gradually after that. And if it emerges that the job market is able to stay steady, then those rate-cut expectations will further diminish, pushing longer term rates higher. That could uninvert the yield curve entirely… [end quote]
Past instances when the yield curve uninverted came because the Federal Reserve reduced the fed funds rate, not because longer term rates rose. This is an important distinction. If long-term bond yields remain high (moreso if they rise) the cost of borrowing will burden businesses and individual borrowers. Especially hard-hit would be zombie companies and real estate.
Here are various Treasury yield curves. A negative 10 year - 2 year spread has been an infallible predictor of recession for decades. Some prefer the 10 year - 3 month spread. These are both deeply negative.
I have never heard of the predictive value of a “near-term forward spread” before. Here’s the Federal Reserve research describing it.
The Near-Term Forward Yield Spread as a Leading Indicator: A Less Distorted Mirror
Eric C. Engstrom, Steven A. Sharpe
Abstract:
The spread between the yield on a 10-year Treasury note and the yield on a shorter maturity security, such as a 2-year Treasury note, is commonly used as an indicator for predicting U.S. recessions. We show that such “long-term spreads” are statistically dominated in models that predict recessions or GDP growth by an economically more intuitive alternative, a "near-term forward spread (NTFS)."The latter can be interpreted as a measure of the market’s expectations for the near-term trajectory of conventional monetary policy rates. Its predictive power suggests that, when market participants expected—and priced in—a monetary policy easing over the subsequent year and a half, a recession was quite likely in the offing. We also find that the near-term spread predicts four-quarter GDP growth with greater accuracy than survey consensus forecasts and that it has substantial predictive power for stock returns. Yields on bonds maturing beyond 6-8 quarters are shown to have no added value for forecasting either recessions, GDP growth, or stock returns. [end quote]
Chicago Fed Letter, No. 469, August 2022 Crossref
Sources of Fluctuations in Short-Term Yields and Recession Probabilities
By Andrea Ajello , Luca Benzoni , Makena Schwinn , Yannick Timmer , Francisco Vazquez-Grande
The NTFS closely mirrors market participants’ expectations for the trajectory of the Federal Funds rate over the near future. Such expectations are influenced by views about the business cycle and monetary policy. For instance, if market participants anticipate a recession, they will also likely expect that monetary policymakers will lower the policy rate to provide accommodation. The expectation of lower future rates reduces forward rates, resulting in a negative NTFS. Thus, to the extent that markets’ expectations are correct, a negative NTFS is associated with a heightened recession probability. … [end quote]
One would think that such an important predictive statistic – one which Fed Chair Jerome Powell has confidence in – would be included in the FRED database. I searched but I can’t find it. I also can’t find a clear description of where the Fed gets its number for the 18-month forecast of the bond market.
The NTFS is rising slightly but it is still deeply negative.
The effective fed funds rate today is 5.08%. The WSJ chart is showing that the market expects the fed funds rate to be 4% in 18 months. The CME Fedwatch tool shows a market consensus between 3.5% - 4.0% in December 2024.
In the past, the Fed has cut the fed funds rate because a recession was starting. But the current optimistic case would be that the market expects inflation to recede and the Fed to back away from its campaign of rate increases – hopefully with a soft landing.
Wendy
