By Yoruk Bahceli, Tom Westbrook and Dara Ranasinghe
(Reuters) – As central banks raise interest rates at a pace not seen in decades to control inflation, a warning is spreading among bond investors about the risks of an impending recession.
This week alone has seen major central banks provide 350 basis points for rate hikes.
Bond yield curves, which are seen as good indicators of the direction of growth and inflation, indicate that the magnitude of higher interest rates will slow growth sharply.
Long-term returns are usually higher than short-term returns to compensate investors for securing their money for a longer period. When the curve inverts between them, it usually means there is a problem ahead – in the US such a reversal is seen as one of the most famous indicators of a recession.
The US Treasury yield curve is now pushing deeper into negative territory.
Even in Germany, where long-term bond yields remain higher than short-term bond yields, the yield curve is closer to inverting than it has been in years.
“Central banks have been fighting high inflation for four decades and will err on the side of doing more, and of maintaining higher rates for longer, than the other way around,” said Damian McCullough, head of price strategy at Westpac in Sydney.
Here’s a look at what’s happening in the key markets and why.
1 / Echo of 2008
Since the European Central Bank’s unprecedented rate hike of 75 basis points on September 8th, investors have begun to brace for big hikes that will sharply slow economic growth.
Since last week, Germany’s yield curve measured by the gap between 10- and 30-year yields and 5- and 30-year yields has inverted..
On Thursday, the closely watched gap between two-year and 10-year bond yields narrowed to less than one basis point, close to reversing for the first time since 2008.
In the swap market, which is seen as a better measure of monetary outlook and where investors hedge interest rate risk by paying a fixed swap rate to receive floating rate cash flows, the two-year/10-year prime tranche has already flipped.
The curve reversals “should continue further given the ECB’s intention to control and raise inflation expectations in the face of a recession,” said Nick Sanders, portfolio manager for Alliance Bernstein (NYSE:NYSE:).
Investors are now expecting eurozone interest rates to peak near 3.25% in late 2023 compared to their forecast of 2.2% before the latest ECB hike.
Graphic – Germany’s curve is close to inverting
2 / Driving on the road
Of course, one reason for the inversion of global bond curves is the escalation of US borrowing costs, which could slow growth sharply.
The Federal Reserve raised interest rates by 75 basis points. The US 10-year payment yield curve fell on Thursday to -57 basis points, its biggest reversal since at least 2000.
The reversal has deepened since Fed Chairman Jerome Powell’s Jackson Hole remarks that stressed that the bank would raise as high as needed to constrain growth and keep interest rates at this point “for some time”.
Since then, traders have climbed as they saw peak rates to 4.50%-4.75%, from 3.75%-4.00%.
Citi says the possibility of a recession in 2023 is increasing given the Fed’s hawks.
Graphics – How far can the US curve be reversed?
In Britain, the yield curve has already reached its most inverted level since 2008, indicating that investors may be preparing for a deep and prolonged recession.
Britain has the highest inflation among the world’s major rich nations, and is probably already in a shallow recession.
The gap between the two-year and 10-year bond yields is around -17 basis points, after falling to -37 basis points in late August with fears of a toxic combination of high inflation, high rates and weak growth hitting the pound and gold.
“We see little from the BoE to change the dynamics of the current yield curve flattening,” said Chris Lupoli, UK inflation analyst and inflation strategist at BNP Paribas (OTC :).
Graphic – Reversal of the British Gilded Curve
4/ Out of shape?
Asia, Singapore and South Korea may see the strongest warning signs.
Singapore’s curve, which closely follows the US, is inverted by -14 basis points, deeper than the 2006 reversal that preceded the recession.
And South Korea’s seven basis point reversal is comparable to the levels of the financial crisis.
In other parts of Asia, interest rate cuts have hampered China’s curve reversal, while Japan has been struggling for a long time in the 10-year period due to the Bank of Japan’s 0.25% yield cap.
Graph – Korea’s curve is also inverted