Caution: Curves Ahead

by | March 28, 2022

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. 

So, what is the bond market telling us? 

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. 

Drive carefully.  

About the Authors

Larry Hatheway

Larry Hatheway has over 25 years experience as an economist and multi-asset investment professional. He is co-founder, with Alexander Friedman, of Jackson Hole Economics, LLC, which offers commentary and analysis on the global economy, policy & politics, and their broad implications for capital markets. Prior to co-founding Jackson Hole Economics, LLC Larry worked at GAM Investments from 2015-2019 as Group Chief Economist and Global Head of Investment Solutions, where he was responsible for a team of 50 investment professionals managing over $10bn in assets. While at GAM, Larry authored numerous articles on the world economy, policy-making and multi-asset investment strategy. Larry was also the lead investment manager for various mandates, funds and an actively managed multi-asset index. Larry also served on the GAM Group Management Board, was Chairman of the GAM London Limited Board and served as member of the GAM Investment Management Limited Board. Larry was also Chairman of the GAM Diversity & Inclusion Committee. During his tenure at GAM, Larry was based in London, UK and Zurich, Switzerland. From 1992 until 2015 Larry worked at UBS Investment Bank as UBS Chief Economist (2005-2015), Head of Global Asset Allocation (2001-2012), Global Head of Fixed Income and Currency Strategy (1998-2001), Chief Economist, Asia (1995-1998) and Senior International Economist (1992-1995). During his tenure at UBS, Larry was also a standing member of the UBS Wealth Management Investment Committee. While at UBS, Larry worked in Zurich, Switzerland, London, UK (various occasions), Singapore and Stamford, CT. At both GAM Investments and UBS Investment Bank Larry was widely recognized for his appearances on Bloomberg TV, CNBC, the BBC, CNN and other media outlets. He frequently published articles and opinion pieces for Bloomberg, CNBC, Project Syndicate, and The Financial Times, among others. Before joining UBS in 1992, Larry held roles at the Federal Reserve (Board of Governors), Citibank and Manufacturers Hanover Trust. Larry Hatheway holds a PhD in Economics from the University of Texas, an MA in International Studies from the Johns Hopkins University, and a BA in History and German from Whitman College. Larry is married with four grown children and a loving Cairn Terrier, and resides in Wilson, WY.

Alex Friedman

Alex Friedman is the co-founder of Jackson Hole Economics, LLC, a private research organization which provides analysis on economics, politics, the environment and finance, and develops actionable ideas for how sustainable growth can be achieved. Friedman is a senior leader with two decades of experience growing and transforming organizations in the financial and non-profit industry. He was the CEO of GAM Investments in London and chairman of the firm’s executive board. Previously, he was the Global Chief Investment Officer of UBS Wealth Management in Zurich, chairman of the UBS global investment committee, and a member of the executive board of the private bank. Before moving to UBS, Alex Friedman served as the Chief Financial Officer of the Bill & Melinda Gates Foundation. He was a member of the foundation’s management committee, oversaw strategic planning, and managed a range of the day-to-day operating functions of the world’s largest philanthropic organization. Friedman also created the foundation’s program-related investments group, the largest impact investing philanthropic fund in the world. He started his career in corporate finance at Lazard. Friedman served as a White House Fellow in the Clinton administration and as an assistant to the U.S. Secretary of Defense. He is a member of the board of directors of Franklin Resources, Inc. (Franklin Templeton), a member of the Council on Foreign Relations, Chairman of the Advisory Board of Project Syndicate and a board member of the American Alpine Club. Friedman is a regular contributor to a range of newspapers and thought leadership groups and is also the author of Babu’s Bindi, and The Big Thing, both children’s books. He is an avid mountaineer and rock climber and led the first major climb to raise money for charity through an ascent of Mt. McKinley. Friedman holds a JD from Columbia Law School, where he was a Harlan Fiske Stone Scholar, an MBA from Columbia Business School, and a BA from Princeton University.

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