Yield curve recession signal intensifies as war fuels ‘stagflation’ fears

By Davide Barbuscia

NEW YORK (Reuters) -Recession concerns are showing up more prominently in the U.S. Treasury yield curve, as soaring commodity prices in the wake of Russia’s invasion of Ukraine fuel worries over inflation and slower growth.

The closely watched gap between yields on two- and 10-year notes stood at its narrowest since March 2020 on Friday, a signal that some investors may be anticipating that economic growth will slow from its current robust pace.

On a two-month rolling basis, the 2s/10s flattening has been its most extreme since 2011, said Jonathan Cohn, head of rates trading strategy at Credit Suisse (SIX:CSGN).

Market participants watch the yield curve for insight into the U.S. economy. An inverted curve, where rates on short-term government debt exceed those on longer-term debt, has reliably predicted past recessions.

Investors said the most recent moves appear driven by worries that prices for oil and other raw materials, which have spiked after the invasion of Ukraine by commodity-export giant Russia, will add to already-high inflation, forcing the Fed to tighten interest rates even if growth slows.

While expectations of a 50 basis-point hike this month have been all but priced out in recent weeks, markets still expect over 150 basis points of tightening by next February. [FEDWATCH]

“If central banks prioritize fighting inflation in 2022, having failed the world on that front in 2021, then hiking into a stagflationary environment likely means they are accepting some sort of recession is necessary to sort the whole mess out,” said Jeffrey Halley, senior market analyst, Asia Pacific, at OANDA, referring to a blend of weak growth and strong inflation.

Brent crude oil prices approached $120 a barrel on Thursday, their highest level since 2012, after a fresh round of U.S. sanctions that targeted Russia’s oil refining sector and raised concerns that oil and gas exports could be impacted next.

At the same time, growth appears strong for now: the U.S. unemployment rate fell to a two-year low of 3.8% in February, the Labor Department’s closely watched employment report showed on Friday, raising optimism that the economy could withstand mounting headwinds from geopolitical tensions, inflation and tighter monetary policy.

Still, the curve flattening suggests that may not last.

“Flattening has accelerated as the Fed is seen prioritizing inflation moderation over backstopping risk appetite,” said Cohn of Credit Suisse.