The yield curve is bounding toward inversion as soon as this year as the Federal Reserve lays the groundwork for a rate-hiking cycle set to start next month, according to Bank of America Corp.
The narrowing of the gap between short- and long-term rates -- already underfoot -- is the normal outcome as the economy moves from the mid-point to the later-point of a growth cycle, Bruno Braizinha, the bank’s director of U.S. rates strategy, said in a note. The inversion ultimately happens when the Fed tightens its key rate beyond the neutral level, meaning the central bank’s policy is slowing growth.
“Curve forwards underprice the potential for a curve inversion medium term, seemingly incorporating scenarios of upward repricing of the neutral rate view over time,” Braizinha said. The market sees two options: as “a bullish economic scenario that forestalls the inversion, and a bearish one that sees the curve inverted by” the end of 2022 or early 2023, with the potential for a recession growing by the first half of 2023, he said.
Braizinha foresees the latter case, with an inversion occurring at the end of this year or early next. Inversion are widely considered a reliable harbinger of recession in the U.S., within roughly the following 18 months.
The curve -- as measured by the gap between 2- and 10-year yields -- looks set to be the flattest at the beginning of a Fed tightening cycle in a generation. The spread, at about 41 basis points now, has plunged from a multiyear peak of 162 basis points in March 2021 as traders began to price in Fed interest-rate increases.
Money market traders expect the U.S. central bank to boost the funds rate at their policy gathering next month and bump it nearly 150 basis points in total by the end of this year.
The last time the curve inverted was in 2019, after a string of Fed rate hikes. It was the gap between 3-month and 10-year yields which first went below the zero line in March of 2019, with the 2-to-10-year yield gap inverted about five months later. The pandemic-sparked recession hits in March 2020.
‘Orthodox View’
“There is generally a healthy level of debate at just about this point in the cycle on how curve inversions are not necessarily a strong signal for late-cycle shifts and recessions, and how this time it will be different,” Braizinha said. “We prefer to take a more orthodox view.”
He said the shift into a late-cycle dynamic generally implies “a skew towards liquidity and quality in portfolios, and supports our view for relatively low peak yields for the 10-year Treasury in the current cycle, around 2.25-2.50%.”
This article was provided by Bloomberg News.