Breakingviews: Bond market sends flawed signals on U.S. economy

Russia’s invasion of Ukraine on Thursday upended financial markets. Through the fog, however, trading in U.S. bonds is sending the same two messages that it was before the military assault. One is that there’s a growing risk Federal Reserve Chair Jerome Powell and his colleagues may raise interest rates so quickly that they tip the U.S. economy into recession. The other is that the U.S. policy interest rate won’t rise too much above 2% in this economic cycle. Both signals may be wrong.

The first warning comes from the gap between two-year and 10-year benchmark U.S. bond yields. This spread has fallen by two-thirds in three months to below 0.4 percentage points and is approaching levels that often serve as early warning of an economic contraction. The second comes from money market prices. They imply that the target fed funds rate, currently at a record low of 0-0.25%, will peak at a little over 2%. That’s around where it topped out in 2019, but it’s well below the highs rate-setters have reached in previous cycles.

Neither presumption may be reliable. The Fed has been tardy in reacting to the surge in U.S. annual inflation to a four-decade high of 7.5%. And even policymakers who have previously supported a less aggressive stance, like San Francisco Fed President Mary Daly, have recently changed their tune. But rate-setters know that two mistakes won’t cancel out. They will be vigilant for signs of slowing economic growth and ready to slow or pause rate hikes.

Meanwhile, investors may be overestimating how easily the Fed can bring U.S. inflation back down. Some forces that have driven up consumer prices, such as supply-chain disruptions, may dissipate, though a reversal of the recent oil-price surge will depend on what happens in Ukraine. Other factors won’t fade away. The longer inflation persists, the greater the chance that wages pick up and price pressures become entrenched. This would mean more interest-rate hikes than markets are currently anticipating.

The extra uncertainty thrown into the mix by Russian President Vladimir Putin makes forecasting even more difficult than usual. Safe-haven Treasuries have suddenly become more appealing. But that doesn’t mean they are a reliable compass for the future.

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BREAKINGVIEWS