Caution: Curves Ahead
Traffic engineers do their best to build systems to alert drivers to upcoming risks. Yellow signs with squiggly lines mean curves ahead, slow down and proceed with caution.
Bond markets are full of curves. And the bond market often provides investors and policymakers with useful information about what lies ahead. But unlike road signs, which trace out a known future path, the bond market can only provide probabilities of what the future contours of the economy may look like. Still, the bond market’s signals are worth heeding.
The first quarter of 2022 has provided plenty of action in the bond market. Yields have soared and prices plunged, producing steep losses for investors. Last week, the sell-off intensified, with ten-year government bond yields in the US and Europe reaching their highest levels in four years.
This year’s jump in yields is mostly due to increases in inflation expectations. Since mid-January, US Treasury yields have risen 60 basis points, of which about 45 basis points reflect a rise in expected inflation. Real yields, which strip out inflation, have risen more modestly. They are near the higher end of recent trading ranges, but unlike nominal yields or inflation breakeven rates, they have not yet made new highs in this cycle.
Looking more closely at breakeven inflation rates, almost all the move has been in short and intermediate maturities. Further out the yield curve, for example beyond five-year maturities, inflation expectations remain largely within trading ranges of recent decades. For example, expected five-year inflation five years from now is 2.30%, broadly in line with the Fed’s definition of ‘price stability’.
In short, today’s markets fear inflation for the next few years, but not for longer.
Given that observation, it is perhaps unsurprising that expected rates of inflation in bond markets closely track moves in commodity prices more so than shifts in ‘core’ measures of inflation. In the short run, swings in energy, food, and metals prices can dominate both realized inflation and expectations of inflation.
That is not to say that inflation expectations aren’t sensitive to changes in core measures or in the breadth of today’s inflation readings. Indeed, it can be argued that one reason why investors have been spooked recently by surging commodity prices is that accelerating inflation was already evident across much of the economy.
Nevertheless, it is possible to conclude, however tentatively, that the bond market’s recent rapid sell-off largely reflects concerns about inflation in the near and medium term, rather than as a ‘permanent’ feature of the economy.
That, in turn, suggests three points.
First, investors are confident that central banks will respond forcefully to contain inflation. Evidence for that interpretation is apparent in the very steep curve between cash and two-year note yields, implying considerable tightening over the remainder of this year and into 2023.
Second, investors may also be noting that sharp jumps in inflation mostly reflect soaring energy, food, and metals prices. Insofar as those price increases reflect special factors, such as war and sanctions that historically have been transitory, investors are signaling that inflation will recede as supply disruptions fade.
Accordingly, and this is the third observation, the Cassandra’s concerns about enduring ‘stagflation’ appear overdone.
Fixed income markets are also sending other signals. In the US, the yield curve, as measured by the difference between two- and ten-year yields, has flattened dramatically. Today that gap is about 20 basis points, compared to a spread of nearly 150 basis points one year ago. A flattening yield curve typically reflects expectations for tighter monetary policy and slower growth.
Indeed, the combination of a flatter yield curve, subdued real interest rates and expectations for lower future inflation suggests that investors now anticipate slower growth and falling inflation.
That is not the same thing as an economic recession. Based on past statistical inference, bond markets are not yet projecting outright declines in GDP. Recession probability models, which typically incorporate information from the yield curve, still suggest that recession risk over the next 12 months remains below 10%. The curve typically inverts at various maturities prior to a recession, which is not yet the case.
Nevertheless, shifting curves (and other bond metrics) are warning signals, which should be heeded.
For example, although bond investors collectively believe that real GDP growth will only decelerate, rather than fall into recession, slowing economic activity could produce an outright decline in corporate profits. According to FactSet, first quarter 2022 corporate earnings are already slipping below a 5% annual growth rate, their slowest pace of expansion in five quarters. Moreover, negative earnings pre-announcements are running at their highest level since 2019.
Economy-wide corporate profits and profit margins are highly correlated to the business cycle. They also exhibit ‘excess volatility’ relative to GDP growth — surging during recoveries and collapsing in recessions. The implication is that with earnings growth already fading to mid-single digit levels, it may only take an economic slowdown (rather than a full-blow recession) to push earnings growth into negative territory.
Moreover, the combination of tighter monetary policy, falling real wages, and fiscal tightening suggests that the risks to future economic and profits growth are skewed to the downside. Weaker growth is apt to arrive by mid-2022. If so, corporate profits may fall before year end. That’s not a great message for a US equity market that commands a valuation some 20% above its long-term average. Weaker growth and a wobbly equity market also do not bode well for Democrats, who as the party in power will face the voters in November’s mid-term elections against a backdrop of weakening economic fundamentals.
The bond market is sending signals. It pays to heed them. The post-pandemic economic and earnings bounce is now in the rear-view mirror, and the road gets trickier from here.