The recession alarm is ringing on Wall Street, as the bond market spooks investors
- The US bond yield curve has flattened dramatically in recent weeks, raising fears about slower economic growth.
- Some investors expect the curve to invert in the coming months – a classic recessionary signal.
Investors scrutinize the bond market every day for signs of danger coming down the tracks.
Right now, many don't like what they see. Chatter about whether or not the US is headed for a recession is growing louder by the minute.
The US Treasury yield curve, a graph that plots the yields of different government bonds, has inverted ahead of every recession since the 1950s. That's made it the most closely watched growth indicator on Wall Street.
It's flattened dramatically in recent weeks as markets have ramped up their expectations for the number of Federal Reserve interest rate hikes this year, which means yields on shorter-dated debt are catching up to those on longer-dated bonds.
And although the curve hasn't inverted yet, some investors think it could do so in the coming months.
The gap between the yields on the 2-year and the 10-year Treasury has fallen to around 40 basis points, Fed data shows, its smallest since April 2020. Some parts of the curve have already inverted, with the 10-year yield falling below the 7-year yield on Monday.
Jeffrey Gundlach, the investor often known as the "Bond King", told CNBC last week the US economy could fall into recession in 2022.
"The yield curve has us on watch already," he said. "Once you get the yield between the 10-year Treasury and 2-year Treasury inside of 50 basis points, you're on recession watch. And that's where we are."
However, most investors think fears about a recession are overblown, even if pessimism is becoming more common.
Only 12% of fund managers around the world are predicting a recession, according to a Bank of America survey released Tuesday, although 30% expect a bear market in which stocks could fall more than 20%.
The yield curve is flattening because investors are expecting the Fed to raise interest rates aggressively in 2022 as it grapples with the strongest inflation in 40 years. Goldman Sachs is predicting seven rate hikes.
The 2-year yield, the most sensitive to Fed interest rate expectations, has shot up from around 0.22% in November to close to 1.6%. If interest rates go up, the fixed returns on bonds become less attractive. That pushes up yields, which move inversely to prices.
Longer-dated yields are also rising, but not as quickly. To many investors, this suggests the Fed's rate hikes will lead to slower growth in the future.
If growth prospects look good, then investors will want to hold riskier assets such as stocks and so they'll sell bonds, pushing up their yields. But if the outlook is cloudy, investors will want to hold government bonds, which are ultra-safe, keeping prices higher and yields lower.
"The curve could invert within the year," Seema Shah, chief strategist at Principal Global Investors, said.
However, she said an inversion may not be the reliable signal it once was, because the huge quantities of government bonds now owned by central banks are suppressing long-term yields.
Top JPMorgan strategist Marko Kolanovic told clients in a note this week not to worry.
"We think it is wrong to position for a recession given still extremely favorable financing conditions, very strong labor markets, under-leveraged consumers, strong corporate cash flows and banks' strong balance sheets," he wrote.
Kolanovic said the sell-off in stocks – the S&P 500 is down more than 7% for the year – has gone too far, saying that the economic cycle is "far from over."