Yield curve sends strongest recession warning since 2007
A widely watched bond market indicator sent its strongest recession warning in more than a decade on Wednesday, as the global growth outlook dimmed and questions swirled about the Federal Reserve’s commitment to cut interest rates in light of rising US-China trade tensions.
The yield on three-month US Treasury traded as much as 41.23 basis points above that on the benchmark 10-year government bond — the widest gap since March 2007. Such an inversion of the yield curve — in which short-term yields are higher than longer-term ones — has preceded every recession of the last half century.
The difference narrowed by about 10bp later in the day as US stock prices gained ground and a government bond market rally lost steam, but the persistence of the yield curve inversion underscored the anxieties in global financial markets.
Analysts said fears about global growth were exacerbated by interest rate cuts by New Zealand, India and Thailand, a dismal industrial production report in Germany and the growing likelihood that the UK will leave the EU without a deal in October.
“The next recession couldn’t have been better telegraphed,” said Mark Holman at TwentyFour Asset Management. “There is a trade war between the two global superpowers with both sides digging in their heels and the clock is ticking towards a hard Brexit, so it really does make sense to take risk off the table.”
Michael de Pass, the global head of US Treasury trading at Citadel Securities, said the deeper inversion of the yield curve traced back to concerns the Fed is moving too slowly to lower rates.
“The message that the market appears to be sending is that the Fed is behind the curve and is at risk of a policy error,” he said. “It is too early to say whether it actually is behind the curve but that line of thinking has certainly been a key driver of price action over the last few sessions.”
Comments by James Bullard, St Louis Fed president, on Tuesday, deepened these concerns, according to John Briggs, the head of strategy for the Americas at NatWest Markets. At an event for the National Economic Club in Washington, Mr Bullard said it was unrealistic to expect the Fed to react to trade rhetoric.
“If you tried to respond every time there’s a threat or counter-threat in a tit-for-tat trade war, you would destabilise monetary policy,” he said.
Mr Bullard said the Fed had already responded in July to what he called “trade uncertainty.” July’s rate cut, he said, was “insurance” against what was not known about the trade situation.
Chicago Fed President Charles Evans toed a more dovish line on Wednesday, signalling to Reuters his support for further rate cuts given that inflation remains persistently below the Fed’s 2 per cent target.
But investors are still worried that the Fed will deliver when it comes to easing monetary policy in line with market expectations.
“Until we get some sort of indication that the Fed is open to additional action, the yield curve will continue to invert,” Mr Briggs said.
Traders are pricing in a more than 60 per cent chance the Fed slashes its benchmark interest rate by 25bp in September, with nearly 40 per cent betting on a more aggressive 50bp cut.