Tuesday, April 26, 2022
In this week’s Weekly Market Commentary (found here) we took a closer look at some of the economic data to see if it is signaling a near-term recession. For us, recessionary risks have increased this year but we think the economy could escape a recession in the near term, with potential for nearly 3% growth this year. Moreover, we think the economy is stable enough and the job market is robust enough to handle the current rate hike expectations. That said, while we have confidence in our interpretation of the economic data, it’s important to confirm (or refute) our views relative to market signals. As such, below are three bond market charts that, to us, confirm that the economy is potentially poised for a mid-cycle slowdown and not an imminent recession.
- Despite the significant repricing of rate hike expectations this year and all the jawboning from Federal Reserve (Fed) officials about doing whatever it takes to arrest consumer price increases, market-implied inflation expectations have started trending higher again. If markets thought the Fed was going to engineer a hard-landing (recession) through aggressive rate hikes, inflation expectations would likely be falling at this point. That they’ve continued to move higher recently may suggest markets think the Fed will not completely abandon its dual mandate and detrimentally sacrifice growth to fully arrest consumer price increases. That also likely means the market expects inflationary pressures to remain above the Fed’s 2% target for longer.
“Bond markets are clearly pricing in an economic slowdown this year but not a recession, in our view,” noted LPL Financial Fixed Income Strategist Lawrence Gillum. “We’re still likely to grow above trend in 2022 and we don’t see anything in the bond markets currently to suggest otherwise.”
- After briefly inverting, U.S. Treasury yield curves have steepened recently and, as seen on the LPL Chart of the Day, the much followed 2-year/10-year tenors on the yield curve are upward sloping again. While we wrote several weeks ago that the then current yield curve inversion was likely premature and not foreshadowing an imminent recession, re-steepened curves confirm that view. That said, the yield curve is still very flat so we’re likely going to see periodic inversions/steepening throughout the year as the Fed actually follows through with rate hikes.
3. The return distribution for credit investors is asymmetrical, which means the potential for losses can be magnitudes larger than the potential for gains. So, credit markets tend to react quickly when economic or corporate credit conditions start to deteriorate. A Credit Default Swap Index (CDX) is a benchmark index that tracks a basket of U.S. corporate credit issuers and tends to act like an insurance policy in the case of an issuer’s default. As seen below, credit default swap indexes have increased this year but remain well within normal ranges. Moreover, coming into the year corporate credit markets were priced to perfection, so a marginal increase in spreads to back in line with historical averages is warranted and consistent with a less supportive economic environment.
We acknowledge that given the nuances surrounding current economic dynamics and with the Fed likely to respond more aggressively than previous rate hiking campaigns to arrest stubbornly high consumer price increases, recessionary risks have likely been pulled forward into 2023/2024. However, we still expect the economy to grow above trend this year given the underlying strength of the consumer.
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