U.S. government bond yields are signaling almost no chance of the economy slipping into another recession even as stocks and commodities tumble, according to research from the Federal Reserve Bank of Cleveland.
The 2.34 percentage point gap between yields on two-year and 10-year Treasuries is more than double the 20-year average and about the same as in 2003, just before gross domestic product rose 3.6 percent. The so-called yield curve suggests growth won’t slow to less than 1 percent and about a 12 percent chance of a recession in the next year, Joseph G. Haubrich, head of the banking and financial institutions group at the Cleveland Fed, and Kent Cherny, a researcher, wrote in a July 1 report.
Market rates conflict with growing concerns that the U.S. economy will contract for the second time in three years. Bond returns exceeded stocks by the widest margin in nine years during the first half as investors retreated from higher-yielding assets. The Labor Department reported the first drop in employment this year on July 2. At the same time, Wall Street expects bond yields to rise as the U.S. expansion continues.
“We could get a sharper move to higher yields once growth dynamics take hold,” James Caron, head of U.S. interest-rate strategy at Morgan Stanley in New York, said in a July 2 interview on Bloomberg Television. “We still expect 3.5 percent growth this year.”
The U.S. economy grew at a 2.7 percent annual rate in the first quarter, the Commerce Department reported June 25.
Morgan Stanley, one of the 18 primary dealers of U.S. government securities, predicts 10-year yields will rise to 3.5 percent by year-end, from 2.98 percent last week. The yield has dropped from this year’s high of 4 percent on April 5 amid signs the economy is slowing. The yield was little changed at 2.98 percent at 9:37 a.m. in New York.
While bonds rallied, the Standard & Poor’s 500 index of stocks has dropped 8.3 percent this year and the Thomson Reuters/Jefferies CRB Index of 19 raw materials declined 10.2 percent.
The difference between 2- and 10-year yields shrunk to as little as 2.28 percentage points on July 1, the least since October, from a record 2.94 percentage points on Feb. 18. That was after the Fed raised its discount rate for the first time since 2006.
While an inverted curve is known for predicting recessions, a steep one is generally a signal of growth, wrote Joseph G. Haubrich, head of the Cleveland Fed’s banking and financial institutions group, in the research note. An inverted curve reflects expectations for higher interest rates and slowing inflation. A steeper curve shows investors demanding increasing compensation for the risk that faster economic growth will spur inflation that diminishes the value of bonds’ fixed payments.
The curve inverted, with 2-year yields topping 10-year yields, before each of the last seven recessions. There were two “false positives,” where higher short-term rates didn’t precede a recession, Haubrich and Cherny wrote in the report. Haubrich and Cherny weren’t available for comment.
Projections of the three-month Treasury bill to 10-year note curve, using past values of the spread and GDP growth, suggest the economy will strengthen by about 1 percent even with some data suggesting a slowdown, they wrote.
Economists are forecasting the U.S. economy will grow 3.2 percent this year, and 2.9 percent in 2011, according to the median forecast of 66 economists in a Bloomberg News survey. The economy shrank 2.4 percent in 2009.
“Things are still growing but just at a slower pace,” said William O’Donnell, U.S. government bond strategist in Stamford, Connecticut at Royal Bank of Scotland Group Plc, another primary dealer. “It’s way too premature to say we’re headed to another double dip.”
While Morgan Stanley’s forecasts for growth and yields are among the high-end of 67 strategists and economists surveyed by Bloomberg, even firms that say the economy is weakening advise investors to dump Treasuries because yields are too low relative to growth prospects. Citigroup Inc., also a primary dealer, issued a report on July 1 that concluded 10-year yields are about 70 basis points below fair value.
“Concerns over a double dip now overstated,” Brett Rose, a fixed-income strategist at the New York-based firm, wrote in the report.
Kenneth Rogoff, the Harvard University professor and former International Monetary Fund chief economist, said economic recoveries under way now “are very slow.” At the same time, “the fact that we’re not growing super fast doesn’t necessarily say, well, therefore we’re about to enter something worse,” he said in an interview with Bloomberg Television in Hong Kong.
Sentiment may already be shifting. The yield on the benchmark 3.5 percent note due May 2020 rose three basis points, or 0.03 percentage point, on July 2 even after the Labor Department in Washington said the economy lost 125,000 nonfarm jobs in June. Investors in a weekly survey by Ried Thunberg ICAP, a unit of ICAP Plc, the world’s largest inter-dealer broker, became more bearish.
The firm’s index on the outlook for Treasuries through December fell to 40 as of July 2, matching the lowest reading of the year, from 44 a week earlier. A figure less than 50 shows investors expect prices to fall. The company, based in Jersey City, New Jersey, said it surveyed 26 fund managers overseeing $1.38 trillion.
Bond bears have been wrong this year. Two-year note yields dropped to a record low of 0.59 percent on June 30, before ending last week at 0.62 percent. Ten-year yields fell 13 basis points last week to 2.98 percent.
Ten-year note futures due in September gained 13/32 to 122 23/32 yesterday while U.S. markets were closed for the Independence Day holiday.
The curve will end 2010 at 2.33 percentage points as 2-year yields jump to 1.37 percent and 10-year yields rise to 3.70 percent, according to the median forecasts of 65 economists in a Bloomberg survey.
“There is no question that folks in the market are worried about a double dip but for the most part their concerns are more reflective of things they expect to happen and not so much a reaction to data from the past months,” said Stephen Stanley, chief economist at Pierpont Securities LLC in Stamford, Connecticut, and a former Fed economist.
Bond returns exceeded stock gains in the first half by the widest margin since 2001, when the economy was in a recession. While the MSCI World Index of 24 developed countries fell 9.5 percent including dividends, bonds gained 4.2 percent, the Bank of America Merrill Lynch Global Broad Market Index shows, reversing the 5.1 percentage point lead stocks had over debt during the same period in 2009.
Indicators of concern about risk in the financial system, including the cost for banks to borrow from each other and the two-year interest-rate swap spread, have leveled off after rising in April and May, implying relative calm in the markets, according to Michael Darda, chief economist with MKM Partners LLC in Greenwich, Connecticut.
The three-month London interbank offered rate, or Libor, was 0.531 percent, little changed from May 25, after rising from 0.29 percent at the end of March, according to the British Bankers’ Association. Two-year swap spreads narrowed to 34.81 basis points today from 52.25 basis points on May 24. The average the previous 12 months is 32.25 basis points.
The spread between yields on investment-grade company bonds and government debt also stopped widening, ending last week at 2.08 percentage points, according to Bank of America Merrill Lynch indexes. That’s about the same as before credit markets began to seize up in mid-2007 and the economy was growing at a 3.2 percent pace.
The widening gap between 10- and 30-year Treasury yields suggests investors are unconvinced a recession and deflation is an immediate risk. The difference was 0.96 percentage point July 2, compared with an average of about 0.43 percentage points since 1990.
“You’re going to be getting respectable levels of growth out of the economy,” said Robert Tipp, chief investment Repo strategist for fixed income in Newark, New Jersey, at Prudential Investment Management, which oversees more than $200 billion in bonds.