US bond market recession trade gets brisk

Rather than wait for conclusive economic evidence, investors are busy buying bonds

The bond market is zeroing in on a US recession next year, with traders betting that the longer-term trajectory for interest rates will be down even as the Federal Reserve is still busy raising its policy rate.

Long-dated Treasury yields are already below the Fed’s overnight benchmark range — currently 3.75 per cent to 4 per cent — and there’s still an extra percentage point of central bank increases priced in for the coming months. Activity has also emerged in the options market that suggests some are hedging against the risk that policy rates could eventually halve from their current level.

Market comfort zone

Rather than wait for conclusive economic evidence that this year’s frenetic monetary tightening will deliver recessionary conditions in 2023, investors have been buying bonds — a stance advocated by Pacific Investment Management Co., among others.

“Fed policy is dynamic and they are still signalling they are going to go higher,” said Gregory Faranello, head of US rates trading and strategy at AmeriVet Securities. “But the market trades like it is more comfortable with the Fed getting to an end game.”

Demand for Treasuries with longer tenors this week dragged the rate on 10-year and 30-year securities below the lower bound of the Fed’s overnight range. With front-end rates holding relatively steady, that’s seen an intensification of the most pronounced yield curve inversion in four decades — a widely watched indicator of potential economic pain to come.

Demand for Treasuries with longer tenors dragged the rate on 10-year and 30-year securities below the lower bound of Fed range.

Economy resilient

“The recession indicator narrative is strong, but from the Fed’s perspective it is part of the solution,” said Faranello.

The US economy — and in particular the labour market — has so far shown itself to be quite resilient in the face of Fed rate increases, which are aimed at trying to curb high and seemingly persistent inflation.