CNBC: The Bond Market is Sounding an Alarm on the Economy

Article by Patti Domm on CNBC

The U.S. economy is more vibrant than it has been in years, yet the bond market insists a recession could be on the horizon.

Some market pros say that warning from the Treasury yield curve, which has long been viewed as reliable, is not as relevant as it once was because of the long years of central bank easing that has depressed interest rates and turned debt markets into far more placid arenas.

The curve has been getting flatter by the day — meaning short-end interest rates are rising faster than long-term rates, and they are growing closer together. A flattening curve is a warning about economic weakness ahead, but should the curve invert— where the short end yield, like the 2-year, is actually higher than the 10-year—that would be viewed as a very solid recession warning.

On Friday, the gap between the 2-year yield and 10-year yield narrowed to just 25.5 basis points, a new 11-year low.

“The bond market is telling us the economic recovery is going to end soon, so let’s price it in with certainty,” said George Goncalves, head of U.S. fixed income rate strategy at Nomura.

Many in the markets are taking the message seriously. Joseph LaVorgna, Natixis chief economist Americas, said the flattening curve is sending a warning, and many investors will see it that way. The financial sector is among the first areas to be pinched when the curve inverts.

"It seems like every day it continues to flatten. it remains to be seen whether this a recession signal but I think it is a signal that the economy is going to soften," said Peter Boockvar, chief investment officer at Bleakley Financial Group. Of the 13 rate hike cycles since World War II, 10 put us into a recession. We've only had three soft landings."

"Inverted curves have always been lurking at the scene of the crime when there's a recession. It's more of a coincident indicator than a causal factor," said Jim Caron, fixed income portfolio manager and managing director at Morgan Stanley Investment Management.

Many strategists say it is simply the Fed’s rate hiking cycle flattening the curve, while inflation is not picking up that much, and there’s fear the economy may ultimately not prove strong enough to withstand all the interest rate hikes it plans.

Goncalves said the Fed will keep going with hikes. "The Fed's going to go through with it anyway. They hiked through an equity meltdown in 2000. The bond market is sounding the alarm, but the Fed is not going to be running to what it perceives to be a false alarm initially, even if things go up in smoke," he said.

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