An often-overlooked recession indicator in the bond market is sounding the alarm for a potential hard landing for the economy, according to analysis from ING Economics.
Tight Correlation in Treasury and Bund Yields
Analysts at ING Economics highlighted a significant correlation between US Treasury yields and Bund yields in Europe. Recent weeks have seen both yields declining as market participants adjust their interest rate expectations in the short term.
Following remarks from the European Central Bank regarding a slowdown in European wages during the fourth quarter, the 2-year Bund yield experienced a slight decrease on Tuesday, hovering around 2.77%. Meanwhile, the US 2-year Treasury yield saw a decline of approximately 7 basis points, trading at around 4.59% on Wednesday morning.
Implications for the US Economy
The tight correlation between Treasury and Bund yields serves as a warning sign for a potential recession in the US, as per ING’s analysis. European central bankers may move swiftly to cut interest rates if the US economy shows signs of faltering, as evidenced during the Silicon Valley Bank crisis in early 2023 when a sell-off triggered synchronized declines in Treasury and Bund yields.
According to ING strategists, the elevated correlation between US and European yields typically suggests a narrative of a hard landing for the US economy, indicating the possibility of a severe recession or a significant disruption.
Divergent Views and Expectations
Despite these warning signals, US investors remain optimistic about the market and economic outlook, particularly in anticipation of interest rate cuts by the Federal Reserve later in the year. The Fed has projected a total of 75 basis points in rate cuts by the end of 2024. However, market expectations indicate a higher likelihood of more aggressive easing measures, with a 60% chance priced in for a full percentage point reduction in rates by December.
ING analysts anticipate that the tight correlation between US and European yields may weaken in the future, allowing European markets to focus more on the narrative of the European Central Bank rather than the Federal Reserve.
Lingering Risks and Economic Outlook
Despite market optimism, economists caution that recession risks persist, especially as the labor market shows signs of weakening. Additionally, inflationary pressures in the economy may keep interest rates higher for longer than anticipated, posing a risk of the Federal Reserve tightening monetary policy excessively and inadvertently pushing the economy into a downturn.
Economic models suggest an increased likelihood of a recession, with some indicating an 85% chance of a recession occurring, the highest probability since the Great Financial Crisis. New York Fed economists are also pricing in a 61% chance of the economy slipping into recession by January of the following year.
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