Recession alarm sounds on Wall Street as bond market spooks investors

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  • The US bond yield curve has flattened considerably in recent weeks, raising fears of a slowdown in economic growth.
  • Some investors expect the curve to invert in the coming months – a classic sign of a recession.
  • Markets have had a wild ride in 2022 as the Fed prepares to hike rates to tackle the highest inflation in 40 years.

Investors scan the bond market every day for signs of danger.

Right now, many don’t like what they see. Chatting about whether or not the United States is heading for a


recession

is getting stronger every minute.

The US Treasury yield curve, a graph that plots the yields of different government bonds, has inverted before every recession since the 1950s. This makes it Wall Street’s most watched growth indicator.

It has flattened considerably in recent weeks as markets have raised their expectations for the number of


Federal Reserve

interest rate hikes this year, which means that yields on short-term debt are catching up with those on longer-term bonds.

And while the curve has yet to invert, some investors believe it may in the coming months.

The spread between 2-year and 10-year Treasury yields fell to around 40 basis points, Fed data showsits smallest since April 2020. Parts of the curve have already reversed, with the 10-year yield slipping below the 7-year yield on Monday.

Jeffrey Gundlach, the investor often known as the “Bond King,” told CNBC last week that the U.S. economy could fall into recession in 2022.

“The yield curve is already putting us on watch,” he said. “Once you get the yield between the 10-year Treasury and the 2-year Treasury within 50 basis points, you’re on a recession watch. And that’s where we are.”

However, most investors think fears of a recession are overblown, although pessimism is increasingly common.

Only 12% of fund managers worldwide expect a recession, according to a Bank of America survey released on Tuesday, although 30% expect a


bear market

where shares could fall more than 20%.

The yield curve is flattening because investors expect the Fed to hike interest rates aggressively in 2022 as it grapples with the highest inflation in 40 years. Goldman Sachs plans seven rate hikes.

The 2-year rate, the most sensitive to Fed interest rate expectations, rose from around 0.22% in November to almost 1.6%. If interest rates rise, fixed bond yields become less attractive. This drives up yields, which move inversely to prices.

Read more: “We’ve seen the lows,” says Fidelity’s global macro director. He lays out the ‘key ingredient’ the Fed uses to keep the stock market stable – and shares the 1 under-the-radar risk that could disrupt it

Longer-term yields also increase, but not as quickly. For many investors, this suggests that Fed rate hikes will lead to slower growth going forward.

If growth prospects look good, investors will want to hold riskier assets such as stocks and will therefore sell bonds, which will increase their returns. But if the outlook is bleak, investors will want to hold government bonds, which are ultra-safe, keeping prices higher and yields lower.

“The curve could reverse within the year,” said Seema Shah, chief strategist at Principal Global Investors.

However, she said a reversal may not be the reliable signal it once was, as the huge amounts of government bonds now held by central banks suppress long-term yields.

JPMorgan chief strategist Marko Kolanovic told clients in a note this week not to worry.

“We believe it is wrong to position for a recession given the still extremely favorable financing conditions, very strong labor markets, under-leveraged consumers, strong cash flow for businesses and strong balance sheets for banks,” he wrote.

Kolanovic said the stock sell-off – the S&P 500 is down more than 7% for the year – has gone too far, saying the economic cycle is “far from over”.

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