International Forecaster Weekly

INVERTED YIELD CURVE SUGGESTING BOND INVESTORS THINK FED WILL RAISE RATES RIGHT INTO A RECESSION

Neil Irwin asks: “When does a report showing a booming job market cause recession alarm bells to start clanging?”

His answer: “When exceptional jobs growth leads bond investors to bet that the Fed will raise rates so aggressively to quash inflation that it will be forced to reverse course later.” That's what happened on Friday.

When the bond yield curve inverts, as it did Friday, it usually means a recession isn’t too far behind. 

And although that's being a tad presumptuous at this point, it's clear the Fed is walking a narrowing tightrope.

The Labor Department’s March employment data was strong again, with 431,000 jobs added, positive revisions to January and February numbers and a slightly falling unemployment rate. 

More Americans are rejoining the labor market, and wages are showing steady growth. 

Just two weeks earlier, Fed chair Jerome Powell said that he sees a "very, very tight labor market, tight to an unhealthy level." 

The new numbers, however, suggest it’s becoming even more so, especially around the government’s headline unemployment rate.

That means the jobs numbers amount to full speed ahead for more aggressive Fed tightening, including what looks likely to be the first half-percentage point rate hike in 22 years at the early May policy meeting.

That's why the jobs numbers caused an 8% jump in 2-year Treasury yields, to 2.46% from 2.28% heading into last weekend. Longer-term yields rose by less, with the 10-year ending the day at 2.38%.

When long-term rates are lower than their short-term counterparts, that's called an inversion or an inverted yield curve, to be more precise. 

It’s like bond investors are betting that the Fed will end up reversing those near-term rate hikes down the road (i.e., lowering them…again), presumably because of a weakening economy.

Guest Writer | April 6, 2022

By Dave Allen for Discount Gold & Silver

Neil Irwin asks: “When does a report showing a booming job market cause recession alarm bells to start clanging?”

His answer: “When exceptional jobs growth leads bond investors to bet that the Fed will raise rates so aggressively to quash inflation that it will be forced to reverse course later.” That's what happened on Friday.

When the bond yield curve inverts, as it did Friday, it usually means a recession isn’t too far behind. 

And although that's being a tad presumptuous at this point, it's clear the Fed is walking a narrowing tightrope.

The Labor Department’s March employment data was strong again, with 431,000 jobs added, positive revisions to January and February numbers and a slightly falling unemployment rate. 

More Americans are rejoining the labor market, and wages are showing steady growth. 

Just two weeks earlier, Fed chair Jerome Powell said that he sees a "very, very tight labor market, tight to an unhealthy level." 

The new numbers, however, suggest it’s becoming even more so, especially around the government’s headline unemployment rate.

That means the jobs numbers amount to full speed ahead for more aggressive Fed tightening, including what looks likely to be the first half-percentage point rate hike in 22 years at the early May policy meeting.

That's why the jobs numbers caused an 8% jump in 2-year Treasury yields, to 2.46% from 2.28% heading into last weekend. Longer-term yields rose by less, with the 10-year ending the day at 2.38%.

When long-term rates are lower than their short-term counterparts, that's called an inversion or an inverted yield curve, to be more precise. 

It’s like bond investors are betting that the Fed will end up reversing those near-term rate hikes down the road (i.e., lowering them…again), presumably because of a weakening economy.

Higher Rates Could Hit Housing Jobs

Despite the steep rise in mortgage rates, the housing market continues to be hot, and — at least through March — generate a healthy stack of new jobs each month.

There are now about 1.8 million people working in real estate services, more than before the pandemic hit.

Friday's strong employment report showed that almost 14,000 new jobs were created in real estate and rental leasing last month, after an average of roughly 11,000 per month over the last year.

The last two years have been the busiest stretch of real estate job creation since the housing bubble was at its pre-bursting level between 2002 and 2005.

When the pandemic hit in early 2020, the Fed cut interest rates to almost zero, mortgage rates plunged, and a housebound nation turned to Zillow. Voila: an employment jackpot.

But now that the Fed's begun raising rates, the 30-year fixed mortgage rate has already bounced to as high as 4.95%—up 65% from just a bit over 3% at the end of last year.

That fast rise could act as a brake on housing activity at some point, potentially slowing job growth in the process.

Employment in residential construction fell by 2,600 in March, according to the government, the largest drop in almost a year.

 

50-Basis Point Hikes Coming Soon

Even more dovish members of the Fed's policymaking Open Market Committee are gearing up for more aggressive rate hikes.

One of those doves, San Francisco Fed Prez Mary Daly, said, “The case for 50 basis points, barring any negative surprise between now and the next meeting, has grown,” 

New York Fed Prez John Williams added that the Fed's tightening "will help bring demand for labor and products in closer alignment with available supply."

The Atlanta Fed’s tracker of markets' expected path of the Fed Funds rate has the Fed policy rate peaking near 3% in the fall of 2023, before drifting downward toward only to 2.5% by the spring of 2025.

But most economists are saying that talk of a recession are premature. 

While the recent trend in bond prices do imply slower growth down the road, they don’t suggest the Fed will overdo its tightening campaign so much that it will soon face an economic downturn.

The 5-year Treasury yield remains higher than the 2-year yield, which is not consistent with a recession in the medium term.

Irwin argues none of this suggests that a 1980s Paul Volcker-era approach of hiking rates to blow up the economy is likely. 

Instead, he believes that markets are pricing in something closer to the Fed's successful "mid-cycle adjustment" rate cuts of 2019 that followed the last yield curve inversion.

Still, there are wide error bands around those market estimates, and it's not as if bond traders have perfect forecasting ability. We still don't know exactly what the economic cost of bringing inflation down will be.

As Williams said over the weekend, "One of the things we've learned from the pandemic is to expect the unexpected."

Thus, expect the uncertainty and volatility to continue.