Recession barometer flashes a new warning sign due to inflation pressures Fed policy

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After June inflation data that showed worse-than-expected price rises, bond markets now show signs of greater investor concern about a possible recession.

On Wednesday, the U.S. 10-year Note Yield fell as much as 0.21% below the yield on its 2-year counterpart, which is the largest difference between the two securities in the past 2000.

Inversions of the yield curve, where shorter-dated bonds yield higher than those with longer maturities, indicate a change in risk attitudes. Investors expect to receive more compensation for holding onto security longer.

The same yield curve inversion. It happened in 2019Before the pandemic, Flashed again in April this year. Before the six last U.S. recessions, there was an inversion of the 2-year/10 year spread.

The spread between U.S. 10-year Treasury yield and yield fell to a depth that was well below the yield. This month, the yield on the U.S. 2-year Treasury was significantly lower than that of October. Source: U.S. Treasury and Federal Reserve Bank of St. Louis

Because the U.S. 2-year yield generally tracks short-term rates, the recent rip higher in yields illustrates market pricing on more aggressive-than-expected interest rate increases from the Federal Reserve.

Investors are most interested in the 2-year/10 year spread as they are the most traded durations on the Treasury curve. However, other tenors along this yield curve have been inverted: The 3-year Treasuries and the 5-year Treasuries have yields that are higher than the 7year.

The curve was briefly inverted after April 2022. It then re-steeped as the Fed began raising interest rates. This had the effect of increasing longer-term rates.

However, this picture is now reversed.

This week, inflation data Last month’s consumer price increase was 9.1% year over year, which cast more uncertainty over the Fed’s ability to avoid recession without abruptly slamming the brakes on economic activity.

“I don’t see an off-ramp to a soft landing anymore,” wrote SGH Macro Advisors Chief U.S. On Wednesday, Tim Duy, economist, said. Duy described June’s Consumer Prince Index (CPI) as a “disastrous” report for the Fed, adding the central bank may have to get more aggressive on raising borrowing costs to depress demand — even if it risks job loss.

“The deepening yield curve inversion is screaming recession, and the Fed has made clear it prioritizes restoring price stability over all else,” Duy added.

WASHINGTON, DC - JUNE 23: Jerome Powell, Chairman of the Board of Governors of the Federal Reserve System testifies before the House Committee on Financial Services June 23, 2022 in Washington, DC. Powell testified on monetary policy and the state of the U.S. economy.  (Photo by Win McNamee/Getty Images)

Jerome Powell, Chairman of Board of Governors of Federal Reserve System, testifies before House Committee on Financial Services, June 23, 2022, Washington, DC. (Photo by Win McNamee/Getty Images

Initial statements by the central bank indicated that it would be discussing between a move of 0.50% or 0.75% at its next meeting. The market responded to the risk by repricing it. As of Thursday afternoon, a 44% probability was placed on a July 27 1.00% move.

Fed attempting to ‘rapidly get up’

Another Learn more about inflationThursday morning’s Producer Price Index, (PPI), showed a similar picture to consumer data Wednesday. Producer prices rose by 11.3% in June year-over-year.

Christopher Waller, Fed Governor on Thursday, stated that so far data had not been reported. Supported the argument for a move of 0.75%, but added that he could change his call depending on data from retail sales — which are due Friday morning — and housing.

“If that data come in materially stronger than expected it would make me lean towards a larger hike at the July meeting to the extent it shows demand is not slowing down fast enough to get inflation down,” Waller said.

Although Waller said markets appeared to show Fed “credibility” on addressing the economic challenge, the deepening yield curve inversion illustrates the tough task ahead as the Fed attempts to raise rates without squeezing companies to the point of layoffs.

WASHINGTON, DC - FEBRUARY 13: Christopher Waller testifies before the Senate Banking, Housing and Urban Affairs Committee during a hearing on their nomination to be member-designate on the Federal Reserve Board of Governors on February 13, 2020 in Washington, DC. (Photo by Sarah Silbiger/Getty Images)

Christopher Waller is a witness before the Senate Banking, Housing and Urban Affairs Committee. This was during a hearing about their nomination for member-designate to the Federal Reserve Board of Governors. It took place in Washington, DC on February 13, 2020. (Photo by Sarah Silbiger/Getty Images

“The business cycle risks rise when the Fed is moving rapidly to catch up,” MKM Chief Economist Michael Darda told Yahoo Finance on Thursday.

Darda added that recession risks could be “dramatically amplified” if yields on T-Bills, the shortest-dated U.S. Treasuries, start to show signs of inversion as well.

“It’s a bit of a dicey situation,” Darda said.

Brian Cheung, a Yahoo Finance reporter, covers the Fed and economics. Follow him on Twitter @bcheungz.

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