Fears that the Federal Reserve may start increasing its fed funds rate from 0.25-0.50% in 50bps steps to curb inflation after this month’s initial 25bps rise are causing US yield curves to flatten and, in some cases, invert now.
Source: Bank of Singapore, Bloomberg.
The first chart shows the spread between 30Y and 2Y Treasury yields has fallen to just 20bps with 30Y bonds at 2.55% and 2Y bonds at 2.35%. Moreover, the chart also shows the spread between 30Y and 2Y swap rates has already inverted for the first time since 2019. Similarly, the widely followed spread between 2Y and 10Y Treasuries is just 12bps now - as the second chart shows - despite 10Y yields surging from 1.50% at the start of 2022 to nearly 2.50% on inflation fears.
Source: Bank of Singapore, Bloomberg.
Historically, an inversion of the 2Y-10Y Treasury curve has reliably signalled a US recession is coming. The Fed’s rate hikes push up short term 2Y yields while 10Y yields lag as bond markets mark down future growth prospects. When 2Y yields exceed 10Y yields and the curve inverts, investors fear the Fed has raised interest rates to the point where the economy will contract.
But even if the Fed starts hiking rates in larger 50bps steps this year than our base case of seven 25bps moves, we think the US economy will still avoid recession in 2022.
First, the 2Y-10Y Treasury spread may not always give a reliable signal of future growth. This month Fed Chair Powell downplayed the 2Y-10Y spread, noting it is ‘hard to have some economic theory on why that would make sense. We of course look at it. I wouldn’t say I don’t look at it. I do. But I tend to look at the shorter part of the yield curve.’ Powell said the spread between 3 months Treasury bills and their forward rate in 18 months’ time seems a more reliable indicator. The second chart shows this ‘near-term forward spread’ is steeply sloped, implying growth is expected to stay resilient despite Fed rate hikes.
Second, economic fundamentals continue to support growth firmly. US real interest rates are negative, labour markets have recovered from the pandemic and reopening, pent-up demand and high savings are strong tailwinds. We thus see the risks of US recession still being low despite yield curves flattening towards inversion now.
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