An Alternative Interpretation of the Famous Recession Indicator: US Inflation Will Drop!
Bank of America(28.69, 0.03, 0.10%) said the Fed could let inflation fall sharply without having to deal with a recession.
The gap between 2-year and 10-year Treasury yields widened to a full percentage point last week, marking the largest inversion in more than 40 years.
The inversion of the 2-year and 10-year U.S. Treasury yield curve, a well-known recession indicator in the bond market, has successfully predicted several recessions, most recently in 1990, 2001 and 2008. Historically, when short-term bond yields were higher than long-term bond yields, it meant investors believed a recession was coming.
This time, however, the indicator reflects more of inflation itself than a hard landing for the economy, BofA said . The bank believes that the US economy can still avoid a sharp decline.
“While curve inversions close to historical extremes are modeled to carry a higher probability of recession, we believe the shape of the curve is driven more by expectations of lower inflation,” strategists said in a note on Thursday. Rather than the impact of deteriorating growth prospects. Digging deeper, forward real rates do not reflect the general consensus of rising recession risks and may instead reflect expectations of a soft landing.”
That’s because forward real yields, which represent market expectations for inflation-adjusted bond yields, have seen only a “modest decline” in the short term, the bank said. That suggests investors expect the Fed to slowly lower interest rates . And they are less likely to make such a forecast if the economy faces a particularly high risk of recession.
“Curve inversion is at historically extreme levels and does not currently reflect rising recession risk, but is largely related to rate cut expectations and inflation moving closer to the 2% target, ” the strategists concluded .
Investors have been eyeing a potential recession for the past year as the Federal Reserve continues to tighten policy to curb inflation.
The U.S. federal funds rate is now at its highest level since 2007, and Fed officials have signaled further rate hikes later this year. Markets are pricing in an 87 percent chance that the Fed will raise interest rates by 25 basis points at its July policy meeting, a move that would raise the target range for the federal funds rate to 5.25-5.5 percent.
Meanwhile, the New York Fed expects a 71% chance that the U.S. economy will slip into a recession next year.