3 Charts stoking market recession fears

Bear in suit faces falling share price stock market crash stock market crash

If you've been following the markets lately, you've probably heard one or two experts say they're worried that the U.S. Economy could slip into a recession, a period of slowing economic activity, or even stagflation, characterized by high inflation, high unemployment, and slow economic growth.

There are now signs that the broader market is beginning to agree with some of these experts about where the economy is headed. Here are two graphs that show why recession fears are on the rise.

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Flattening and inverted yield curves

Investors can watch certain things to determine how the broader market views the economy and whether they believe it is headed for a recession. One of those clues is the U.S. Government bond yield curve. The yield curve shows the interest rates that different U.S. Treasury bills pay depending on the length of the term. There are two-, five-, 10- and 30-year U.S. Treasuries, to name a few.

A treasury bill is, in itself, just a bond issued by the U.S. Treasury to finance U.S. Government spending, but it's important because it also serves as a benchmark for various borrowing rates for consumers and businesses. The yield on the 10-year treasury bill, for example, strongly influences mortgage rates. Longer-term government bonds usually carry higher interest rates because they carry more risk due to longer maturities.

Investors also view treasury bill yields as an indicator of how confident the market is about future economic growth, future inflation, and the future path of the federal reserve's overnight rate (federal funds rate). Recently, the shape of the curve has changed quite a bit.

Data source: U.S. Treasury department. Chart by the author.

The dashed orange line shows the yield curve at 29. March 2021. As you can see, shorter-term U.S. Government bonds typically yield less than longer-term U.S. Government bonds, reflecting a steady curve up and to the right. This is considered normal and is the shape of the curve you see when the market is expecting economic growth. The blue line represents the curve last week, showing how yields are flattening and shorter-term government bonds are rising. From about the two-year treasury bill onward, the curve flattens out, as several government bonds yield roughly the same interest rate. We can see this in more detail if we focus on certain parts of the curve.

2-year treasury bill. Data from ycharts.

In the chart above, you can see that the yield on the two-year U.S. Treasury bill has significantly narrowed the gap with the yield on the ten-year U.S. Treasury bill. Early last week, it briefly overtook the 10-year yield and temporarily reversed that part of the curve, which many economists and market watchers see as a harbinger of a recession. For example, bank of america recently stated in a news story that a reversal in this part of the yield curve occurred prior to the last eight recessions.

If you think about it, the increase in the two-year yield makes sense. At the last meeting, the fed started raising the overnight rate and indicated that it expects six more rate hikes this year and perhaps four more in 2023, which gives the market a pretty good indication of where the prime rate is headed over the next two years: significantly higher. The fact that the 10-year yield has not risen suggests that the market is not as optimistic about long-term economic growth in the U.S. Right now. That's why investors don't usually see it as a good sign when the yield curve flattens out.

In recent days, another part of the curve – the difference between the yield on the five-year U.S. Treasury bill and the 30-year U.S. Treasury bill – has also temporarily inverted. You can't see it exactly in the graph below because it was only a short reversal, but this part of the yield curve hasn't flipped since 2006 (just before the financial crisis) according to bloomberg.

5-year treasury bill. Data from ycharts.

If a recession is imminent?

Not everyone believes a recession is imminent. Fed chairman jerome powell has spoken out against this assumption. Some analysts also believe the yield curve is being manipulated by other factors. First, the fed plans to raise yields very quickly, possibly with a total of 11 rate hikes in 2022 and 2023, which is much faster than during the last rate cycle between 2015 and 2019. The fed has also talked about raising rates by half a percentage point at a time, which would be a departure from their usual 0.25% hikes. These factors could be one reason for the rapid rise in two-year yields.

Another reason is all the money the fed has pumped into the economy since it started quantitative easing (QE), the purchase of U.S. Government bonds and other bonds such as mortgage-backed securities, at the beginning of the pandemic. The fed's balance sheet had already been inflated by QE during the financial crisis. QE can theoretically push down long-term bond yields. Stan shipley, fixed-income strategist at evercore ISI, believes the 10-year yield will rise when the fed starts shrinking its balance sheet, which it has considered doing later this year.

The last point to consider is that the consumer is coming from a position of relative financial strength and unemployment is still quite low, so I don't think a recession is definite, but it is certainly much more likely than it was a few months ago.

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Bank of america is an advertising partner of the ascent, a motley fool company. This article was written by bram berkowitz in english and published on 31.03.2022 on fool.Com published. It has been translated so that our german readers can participate in the discussion.

The motley fool does not own any of the above shares.

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