New York – Market Experts: U.S. Bond Market Recession Signal Not Far Away

New York – The moment when short-dated U.S. Treasury yields rise above longer maturities, a reliable forecaster of recessions, is only two years off at most and could happen in the next year, according to market experts polled by Reuters.

At just 27 basis points now, the gap between two-year and 10-year notes is expected to shrink further to 17 basis points in a year from now, the narrowest since the early days of the financial crisis, as the U.S. Federal Reserve presses on with interest rate rises.

And yet with two more rate hikes expected this year and another two or three next year, the Sept 12-20 poll of over 90 strategists showed both short- and long-term yields will rise only another 30 basis points or so in a year.

“Yields on the long end of the U.S. curve have likely peaked for 2018 when the 10-year crossed back below the 3 percent mark. The interest rate markets narrative has changed…to one more focused on the upcoming recession risks,” noted Guy LeBas, chief fixed-income strategist at Janney Montgomery Scott.

According to the poll, the yield on the two-year Treasury note is forecast to rise to 3.14 percent in a year from now compared with around 2.80 percent on Thursday. The 10-year was expected to yield about 3.30 percent.

That would push the 2-10 year yield spread to about 17 basis points, not seen since June 2007, just over a year before the collapse of U.S. investment bank Lehman Brothers which triggered the worst recession since the Great Depression.

A majority of strategists, 34 of 46, who answered an additional question said the U.S. yield curve will invert – when the yield on short-term maturities are higher than longer-dated ones – within the next two years. That includes 14 who said in a year. The remaining 12 said two to three years or beyond.

The latest survey results line up with a Reuters poll of economists published Thursday that showed a median 35 percent chance of a U.S. recession in the next two years, but also concluded growth would slow to 2 percent by the end of next year, less than half the last reported rate of 4.2 percent.

“While we are not seriously contemplating a recession in 2018, a number of market signals point to a slowdown at the end of 2019 or into 2020,” said LeBas, who expects the yield curve to invert in the next six months.

“More importantly for our purposes, the interest rate market narrative is increasingly focusing on those risks, and it seems likely the markets will start pricing them in with lower long-term interest rates in the back half of 2018.”

Longer-dated U.S. government bond yields have not risen much despite the best economic growth in nearly four years, a series of Fed interest rate hikes and an impending supply of Treasuries to fund a $1 trillion budget gap bloated by aggressive tax cuts.

Extremely low yields on other major sovereign bonds, along with poor recent performance among higher-yielding emerging market securities, have also pushed investors across the globe into the safety of highly liquid U.S. Treasuries.

This is taking place even as Wall Street is scaling new record highs.

The escalating U.S.-China trade war, which every single economist polled by Reuters in a separate survey this week said was bad for the economy, has also put a lid on how high long-term Treasury yields are expected to climb.

“Inflation risk and Treasury issuance should push yields higher,” said James Orlando, senior economist at TD Securities. “(But) if this doesn’t get priced, the current pace of Fed rate hikes will cause the yield curve to invert in the coming year.”

While the majority of respondents said the Fed’s current projected rate path as implied by the dot plots was “just about right”, there were four times as many strategists who said that it was “too hawkish” than “too dovish.”

The trade war with China has also made forecasting the yield curve a bit more difficult.

“I mean at the end of the day if you get a full-blown trade war that creates a lot of market uncertainty, then you tend to get a flight to safety into Treasuries which would tend to keep the curve flatter than otherwise,” said John Herrmann, director of U.S. rate strategy at MUFG Securities.

“But…the risk to that logic is that on one hand, the trade war itself slows the Fed down (on) the front end, so it doesn’t rise as rapidly,” which would steepen the curve, he said.