Danger Zone: Fed’s Economic Recession Alarm Goes Off

A recent drop in the Federal Reserve’s favorite bond market signal has sparked concerns over an upcoming recession. This has increased the likelihood of the central bank cutting rates to revive economic activity. The Fed has concluded that the most reliable bond market signal of an oncoming economic contraction is the “near-term forward spread”. This is the comparison between the forward rate on Treasury bills 18 months from now with the current yield on a three-month Treasury bill. This spread has remained in negative territory since November and has now plunged to nearly minus 170 basis points as of Thursday.

The most recent inversion of the “Powell’s curve” showed that the 18-month US Treasury yield curve is the most reliable indicator of an upcoming recession. The rates strategists from Citi, William O’Donnell and Edward Acton, stated in a note on Thursday that the inversion of the curve continued to drop to new century lows. The inverted curve has not been this low since at least 2007.

The banking system is facing tumult due to the March collapse of Silicon Valley Bank. This has caused investors to worry that credit conditions will tighten and impact economic growth, leading to an increase in recession fears.

The Fed has been on an aggressive rate-hiking cycle in recent years to defeat inflation. The central bank has forecast borrowing costs to remain around current levels till the end of 2023. However, market participants believe that tighter monetary policies are starting to harm growth and are expecting rate cuts later this year.

Fed President James Bullard has recently called for more interest rate hikes, arguing that the Fed should stick to raising interest rates to lower inflation while the labor market remains strong. However, most money market investors expect the Fed to have cut rates by around 70 basis points by December, from the 4.75%-5% current range. Jack McIntyre, portfolio manager at Brandywine Global, stated that the tightening of financial conditions was resulting in credit tightening, and the rate is likely to be lower in the future.

Overall, the market’s faith in the Fed to maintain rate hikes is dwindling, with most investors betting on a rate cut in the coming months to shore up the economic growth rate.

(Reporting by Davide Barbuscia; editing by Ira Iosebashvili and Chizu Nomiyama)