North American Bond Markets Flag A Recession As Central Bankers Continue To Raise Rates
The gap between short- term interest rates and long-term rates has not been this wide in several decades, a growing sign that a recession is in the making. A two-year US Treasury note trades at 4.3% compared to the ten-year bond yielding 3.5%--- a gap of 80 bps. A similar spread exists in Canada where the 2y-10yr gap approaches 100bps. When short-term rates exceed longer-term borrowing costs, it is said that the yield curve has inverted. (Normal yield curves are upward sloping). As the accompanying chart illustrates, the inversion began in the summer when the Fed started to hike rates aggressively and has steadily widen with every rate hike following.
Yield curve inversions is taking place globally, as financial markets anticipate a recession, featuring slow growth and disinflation. The bond market reads that central banks are expected to continue along a war path to tame inflation; the more they hike short rates, the more the curve inverts.
Figure 1 2yr-10yr Treasury Yield Spread
The Bank of Canada Governor, Macklem, has gone on record that jobs must be sacrificed in the pursuit of its 2% inflation target. (This was a politically naïve statement and has resulted in his being accused of instigating class war). A yield curve “inversion” precedes major economic downturns and the extent of this most current inversion has not been experienced since the early 1990s in Canada.
Figure 2 Canadian Yield Curve Inversion
Critics of central bank policy argue that is a mistake to raise rates as the yield curve inverts. Inversion is a clear sign that (a) growth is slowing and will likely turn negative and (b) inflation will come down sharply as growth disappears. In fact, it is now becoming more evident that we have turned the corner on inflation and prices of major commodities, goods, and services, are falling. (Inflation peaking). Given the long lags between instituting a rate hike and its subsequent impact, we can expect that an economic contraction will be apparent later in 2023. This is the position adopted by longer term bond investors and explains why the curve is inverted.
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Disclosure: None.