The difference between the 10-year US Treasury yield and the 2-year US Treasury yield is at its narrowest point since March 2020. The 10-year has a yield of 2.37% while the 2-year is at 2 .14%, a margin of only 23 basis points.
The reversal of these yields is historically an indicator of recession. The yield curve last inverted in August 2019.
“It was an almost perfect recession prediction,” Mr. Coote said.
“The bond market suggests that if the Fed increases eight or nine times, it will lead to bankruptcies and then a recession.”
These alarm bells have not been felt in the stock market. The&The P 500 is up 1.3% since the start of the week while the Nasdaq Composite, which is most sensitive to higher rates, is up more than 2%.
“I think it’s about being vigilant but not alarmed at this point,” said Andrew Mitchell, senior portfolio manager at Ophir Asset Management. “Moving to more defensive businesses that can grow sustainably without paying them through the nose seems like a prudent move to me.”
Economists have been quick to point out that up cycles rarely end without growth stalling, a prospect bond investors welcome.
Capital Economics said that since the late 1970s, 13 of the last 16 cycles of tightening in the US, UK and eurozone have ended in recession.
Fed Chairman Jerome Powell played down the risk of a recession in a speech on Monday.
“The Fed won’t see a 2s 10s reversal” — referring to 2-year and 10-year bond yields — “as a reason to slow the rise in rates…by their measure, they have a record level of slope in their curve to play with before the curve reaches a level flat enough to worry them,” Jim Reid, head of Deutsche Bank’s global fundamental credit strategy, said in the research published this week.
“It should be noted that at the time of the last inversions, there was always a chorus of ‘this time is different’.”
Investors say an interest rate hike could expose a number of “zombie companies”, or companies that can only survive as long as the cost of debt is low, even if the hike cycle doesn’t bring no recession.
“About 20% of the Russell 2000s are zombie companies and their revenues are not meeting their debt obligations,” Mr Coote said.
“They survived because interest rates were going down, but those rates are starting to go up, some of these companies will experience severe turbulence and equity markets will wake up.”