The bond market raises recession fears, but don’t expect one soon

Economists at TS Lombard think the recession prognosticators actually are watching the wrong yield curve.

They say that rather than looking at the spread between 2s and 10s, the more meaningful pair is the three-month bill’s spot price and its 18-month forward, or the market-implied price. That gap “is rising, suggesting a recession is not imminent,” the firm said in a note.

The reason TS Lombard prefers that spread as a gauge is that it reflects monetary policy “and therefore inverts when the market anticipates an easier monetary stance in response to the likelihood or onset of recession.” As things stand, the Fed is indicating that it will continue to raise rates, or tighten policy, something it would not do if it was anticipating a substantial slowdown in growth.

Of course, all that could change if the Fed is wrong, as it has been before in its economic expectations, but economists are urging caution in overestimating the likelihood of a recession.

“While the fast speed of [the yield curve] adjustment and the short distance to zero are notable, it is important to remember the lessons from history and not over-interpret this move,” Oleg Melentyev, credit strategist at Bank of America Merrill Lynch, said in a note.

“The yield curve proceeded to fully flatten by Dec 2005, before turning meaningfully inverted in 2006,” he added. “The financial conditions remained loose through mid-2007, and the credit contraction did not ensue until later that year. In other words, there could be a considerable distance in time between the yield curve at +25bps and a tightening in financial conditions first, the credit cycle turning second, and the economy going into recession third, absent of a policy mistake shortening this distance.”

Indeed, Cleveland Fed President Loretta Mester, one of the central bank’s most hawkish members, said in a recent speech that the yield curve is “just one among several important indicators” she uses as a guide for setting policy.

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