May 22, 2022

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Sirens sound in US economy: Terrible indicator, will recession come?

It becomes more and more upside down

U.S. bond yields have clearly risen since last year, with two-year bond yields rising the most. The two-year return was 0.7% at the beginning of this year and paid more than 2.42% to investors on Wednesday. That was more than the 2.41% payable at 10 years of maturity.

Ten-year yields also rose well: at the beginning of the year it still paid 1.6%, so it rose above 2.4%. However, the rise is far from short-term yields, and historically we can talk about even lower yields.

While this inversion is not yet significant, the flatness of the yield curve is spectacular. The material difference between the yields of maturities of 2, 10 and 30 years has almost disappeared. The picture below shows exactly how the difference between the income for each maturity disappears in a year:

The curve was reversed between 5 and 30-year maturities, with the maximum yield paid on Wednesday by a 5-year bond of 2.56%. This was more than the yield of a 30-year bond reflecting a major reversal rather than a 2-10 year relationship.

What is the reverse yield curve?

In the healthy condition, the yield curve has a positive slope, i.e. the yield level increases from short to long. This is mainly due to the risks that are difficult to predict in the long run: although real economic performance is predictable in a few months, interest rates will not change significantly in 10 to 30 years, and investors expect higher risk. Premiums for long-term investments.

So when the yield is high at low maturity, it indicates that something is wrong.

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Converting the yield curve means that the demand for short-term bonds is lower than for long-term bonds – meaning investors are reluctant or lend their money to the government at higher yields for 1-2-5 years. There could be several reasons for this: one is that they see real economic risks in the future, which could cause resolution problems

Why is yields moving now?

At present, an increase in the interest rate environment triggers an increase in short-term yields. The central bank has already begun to raise interest rates and has so far taken the verbal austerity high – for example, in May, investors are already pricing 50 basis points in line with Fed guidelines, and may tighten in a month. Short-term yield increases are completely natural.

However, a relatively small increase in long-term yields means that investors are already setting lower interest rates for the long term.

One can only guess what the reason for this is: market participants can see the central bank’s delay in taking action against high inflation and expect the central bank to raise interest rates to the extent that it is already affecting the real economy due to stubborn inflation. The central bank will thus break inflation but it will trigger a recession, which will lead to an increase in unemployment – and the central bank will have to cut interest rates in this regard due to its dual target system. Therefore, investors now believe that the interest rate will fall in 10 years rather than 2 years.

Another, more optimistic scenario is that investors will believe that supply side inflation will decrease as the causes (lack of capacity, covetous closures, war disruptions, etc.) decrease and the central bank will not need a further rate hike. From the investors’ revelations, we can conclude that they are more likely to see the first scene.

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Will the recession come?

There is basically no difference between the two scenarios above: Investors say lower interest rates at longer maturities will force the central bank to take over. If you do, it will be due to the recession of the real economy, which means that investors say the recession is already on the horizon. The question is why the opinion of investors is so important, they do not have a glass ball,

But the hard truth is that the US reverse yield curve has so far followed a recession in all cases.

Economists warn that we still do not know if this will happen again. We last talked about the reverse yield curve in 2019, followed by the recession in 2020 – that is, the predictive potential of the reverse yield curve was proven again. In fact, the 2020 recession was not priced in any way by investors, except that it was triggered by an external factor not seen in 2019. Despite the signs of a recession in the real economy by 2019, we will never know if a recession would have occurred without the corona virus.

Apparently, we do not even know if it’s happening now, but the outlook from a year ago is not good. On the one hand, inflation is also threatening, which may actually force the central bank to take strong action: For example, President Jerome Powell already exists Explicitly statedThe central bank is ready to raise interest rates above neutral (At the neutral level, interest rates do not slow or stimulate the economy). So investors are not looking at the glass sphere, but at the market-economic indicators, and they are not very favorable – that is, the reverse yield curve is higher than the fog.

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On the other hand, the self-fulfillment role of the yield curve should not be underestimated: it can turn the yield curve upside down for investors and, as a form of mass psychosis, further reduce risk appetite. Defensive investment policy can spread to the real economy, i.e. contribute to the reverse recession of the yield curve. Of course, the effects of these factors cannot be accurately determined.

Cover image: Getty Images