According to Bank of America, inflation in the US may experience a significant drop, leading to a cooling of prices without necessitating a recession. This conclusion is drawn from the observation of the inverted 2-year and 10-year Treasury yield curve, a well-known indicator of recession in the bond market. Historically, when short-term yields surpass those of longer-term bonds, it has signaled an impending economic downturn.
The inversion between the yields on the 2-year and 10-year Treasury bonds recently steepened to a full percentage point, marking the most pronounced inversion in over 40 years. However, Bank of America suggests that this time the indicator reflects a hard landing for inflation rather than an imminent economic downturn.
In a note on Thursday, strategists at the bank stated, “While curve inversion at historical extremes has garnered higher recession probabilities from models, we think curve shape is more a function of expectations for declining inflation than a deterioration in growth.” They further noted that forward real rates, which represent market expectations of bond yields adjusted for inflation, have only experienced a modest drop in the short-term. This implies that investors anticipate the Federal Reserve to gradually lower interest rates, a move they are unlikely to make if there is a high risk of recession.
The strategists clarified that the extreme inversion levels currently observed do not reflect elevated recession risk but are largely related to expectations for interest rate cuts as inflation converges to the Fed’s target of 2%.
Over the past year, investors have been closely monitoring the possibility of a recession as the Federal Reserve aggressively raised interest rates to curb inflation. Interest rates are now at their highest level since 2007, and Fed officials have indicated the likelihood of more rate hikes later this year. Market expectations currently put an 87% chance of a 25 basis-point rate hike at the Fed’s July policy meeting, which would raise the target Fed funds rate to 5.25-5.5%.
On the other hand, the New York Fed has priced in a 71% chance of the economy slipping into a recession by next year. These concerns have prompted Bank of America to argue that the inverted yield curve is signaling a hard landing for inflation rather than an imminent recession.
In conclusion, Bank of America suggests that the US may experience a significant drop in inflation without facing a severe economic downturn. The inversion of the yield curve is seen as an indication of a hard landing for inflation, and market expectations for gradual interest rate cuts reflect a belief that the economy will not be at a high risk of recession.