The market is made up of lots of differing viewpoints, timeframes, risk appetites, needs for transacting and assessments of true value. That much is assumed. But what is assumed also is that these contradictory forces often oppose each other enough to smoothen lurching between one and another viewpoint. What seems to be happening in the current scenario is that the entire market seems to have one point of view but they’re up against the might of the central banks.
One of the biggest headaches that the world is dealing with is global inflation which is threatening to reduce standards of living globally and push hundreds f millions back into poverty. To counter this, central banks have decided, rightly or wrongly, to attack this with rising interest rates. This course of action is now threatening to push the world into recession, which could be worse for the economically vulnerable if it means a rise in unemployment.
US Long dated Treasuries are now yielding less than the US overnight administered rates (3.75-4%). An inversion of the 2 and 10-year yields signals the market expectation of a recession in the near future. In this case, not only has the 10-year yield fallen below the 2-year yield since July this year but is now below the administered rates- meaning a negative carry cost.
Fig. 1: A recession is on its way: inverted 10yr over 2yr yields.
The inversion of the 2 vs 10, plus the inversion of the 10 and 30-year yields, are the most pronounced as they have been in 4 decades. This is as strong a verdict of the market’s expectations as any of the course of the US economy next year as possible. The question is, what are the expectations of what the Federal Reserve will do on this? What the bond market is hoping for is that the Fed sees the light and reverses course towards lower levels. The current swap market is suggesting that rates will peak at 5% by mid-’23 and then start to come lower by early ’24. Some futures markets are suggesting that administered rates may decline in the US to 3 or even 2% by the end of next year itself. This is setting up the market for some volatility within this dissonance band. This is a big about face from the start of November and based on just one inflation data point!
The trouble with this line of thinking is two-fold: first, the bond market is acting ahead of any hard economic data. There is no evidence that this is actually going to materialise. To that extent the market is jumping the gun and upcoming data- like the ISM manufacturing gauge, the Personal Income and Spending report on personal consumption expenditure (the Fed’s preferred gauge of inflation) will offer more data points on which to build a theory of a future economic trajectory.
Secondly, the Fed has itself stated that it will continue raising rates for longer and to a possibly higher level than expected earlier. So, the market is betting against the Fed going through with what the Fed has explicitly stated that it will go through with. Why are they doing this? Because they think the Fed will blink when it comes to a recessionary scenario. The problem with this is that the Fed is looking to tackle inflation through rate hikes: meaning that it wants to curtail demand. A recession is the fastest way to curtail demand. The Fed may actually be okay with engineering a short recession as a solution and so might stay the course on hiking rates. Furthermore, the labour market is being remarkably resilient in the face of the hikes, and this alone will push the Fed further. There are opposing view of course: Goldman Sachs does not see a recession materialising next year and thinks the 10-year Treasury will find its way back above 4% in due course as inflation remains high and persistent.
But it isn’t just the US where this is occurring: they’ve just been ahead of the curve, so to speak. A ‘global index’ of sovereign yields shows that the average 10-year yield is now below the average 2-year yield. This has not occurred in the last two decades. According to Deutsche Bank, Germany may already be in recession and the US is likely to follow in 2023. What is the central bank line of thinking?
Christine Lagarde suggested just yesterday that she would be surprised if European inflation had peaked- suggesting that they too, would continue their policy of rate hikes. The US Fed has not veered from its messaging about the need for more hikes of its administered rates. In both these cases, the thinking seems to be that inflation is the number one priority. It may seem like a conspiracy theory that the Central Banks are trying to engineer a recession in order to kill inflation and that would make the stance of the market (buy long dated bonds at negative carry in anticipation of central bank rate cuts) a sensible, rational decision. In fact, they could even argue that the central banks wouldn’t mind some inflation as it cuts the nominal value of outstanding government debt.
This is the current situation then: market players are hoping that central banks will pull back on raising rates in the face of the possibility of inflation, while Central banks are hell-bent on controlling inflation because that is their primary mandate and they have limited tools to tackle it with. At this point in time, the market may be getting ahead of itself because most labour markets have not shown signs of weakness- many are winning higher pay contracts even, and corporates are still making record profits across many geographies. The chances are that the larger economies will power through even with higher rates (still negative in real terms) while many smaller nations get damaged with rising debt. Will this make the Federal Reserve change course? Unlikely.