Dow’s 1,000-point drop stokes market fears: Can bonds spy on a recession before the Fed goes too far?

The nosedive followed a brief rally on Wednesday after Federal Reserve Chair Jerome Powell pulled the trigger for the much-anticipated 50 basis point rate hike, the largest since 2000.

It also came as the focus shifted from Powell’s comments that a larger 75 basis point rate hike was not the case something the Fed is actively consideringto what else he said, which is that the Fed will not “hesitate” to deliver higher rates if they are needed.

“Up, down, up, down but mostly down – looks like the market is headed lower indefinitely,” said Brad McMillian, chief investment officer at Commonwealth Financial Network, in comments emailed on Friday.

But for all the drama in stocks, there was another notable move in a key part of the bond market. The benchmark yield for 10-year government bonds TMUBMUSD10Y,
broke through the 3% threshold to climb to 3.124% on Friday, its highest level since Nov. 13, 2018, according to Dow Jones Market Data.

This rate plays an important role in pricing everything from corporate bonds to commercial real estate loans. Its recent surge also brings it closer to a previous peak of around 3.25% in 2018 (see chart) or before it declined before the 2020 pandemic-triggered recession.

10-year government bonds found a peak near 3.25% in 2018 ahead of the 2020 recession

Board of Governors of the Federal Reserve System.

As well as spotting yield curve inversions, the 10-year Treasury yield has a track record of signaling recessions before they happen.

“These bonds are quicker to spot a recession,” Schroders investment strategist Bill Callahan told MarketWatch. “If the Fed keeps raising rates regardless of what’s happening in the economy, those rates will peak.”

signs of a recession

A look into the past on Wall Street doesn’t necessarily predict the future, especially when comparing 2018 to 2022.

“The circumstances are different, in the sense that the inflationary pressures are much more pronounced and real,” Jimmy Whang, head of credit and municipal fixed rates at the US bank, said by phone.

“And the ongoing situation with Russia’s war in Ukraine, coupled with pressure from China’s zero-COVID policy, are headwinds to addressing the supply side of the equation,” he said on Friday.

Because of this, Whang believes the 10-year yield could trend higher than it has historically before finding a new pre-recession peak.

“What we’ve seen in terms of market performance seems to indicate that we’re heading into a somewhat challenging environment as the Fed heads for a soft landing,” he said.

US stocks ended a turbulent week lower, contributing to annual declines, with the S&P 500 Index SPX,
13.5% in 2022, the Dow DJIA,
up 9.5% and the tech-heavy Nasdaq Composite Index COMP,
22.4% lower.

In addition to a rise in Treasury yields – a key factor in this year’s bond market painful slide – is the yield on US high yield or “junk” bonds recently over 7%according to the ICE BofA US High Yield Index, or the highest level in about two years.

“We’re in a new regime when you think about coming out of the global financial crisis,” said John McClain, portfolio manager for Brandywine Global Investment Management’s high yield and corporate credit strategies.

“Up until late last year, central banks were busy trying to quell volatility and bail out markets,” McClain said over the phone. “The opposite is true today.”

Where are the markets? Steve Friedman, a senior macroeconomist on MacKay Shields’ fixed income team, said a lot depends on what happens over the next few months with inflation, which is tied to an 8.5% annual rate in March when the Fed hikes rates .

“There’s a sense that next year policy will have to step into hawkish territory,” said Friedman, a former Fed official, even if it means triggering a recession.

“I think there are legitimate concerns about how a soft landing will come about,” he said. “The narrative is a little unconvincing to market participants and unconvincing to me.”

continue reading: Critics ignore Fed’s new tool to fight inflation, officials say

Next week’s US economic data includes the April CPI on Wednesday, followed by weekly jobless claims on Thursday and May consumer sentiment data from the University of Michigan on Friday. Dow’s 1,000-point drop stokes market fears: Can bonds spy on a recession before the Fed goes too far?

Brian Lowry

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