US bonds flag recession risk with 75 bps hike in play

The hottest US inflation in four decades will push the Federal Reserve to raise interest rates more aggressively this year, and a recession may not be far behind.

Those are the dramatic signals coming from markets as traders continue to assess the latest inflation surge. On Monday, a closely-watched part of the US yield curve inverted on growing concern that tighter monetary policy will take a bigger toll on economic growth.

Money markets are pricing 175 basis points by the Fed’s September decision, implying two half-point and one 75 basis-point hike, according to interest rate swaps tied to FOMC policy outcome dates. They had only fully priced half-point hikes previously.

The Fed hasn’t hiked by three quarters of a percent since 1994, and tightening of this magnitude is fueling concerns of reduced consumer spending and business activity. That’s sparked a global equity selloff and pushed the US S&P 500 closer to a bear market. Short-term yields that are higher than long-term yields are abnormal, and are historically seen as heralding a potential recession.

Amid the market tumult, all eyes will be on this week’s Fed statement and Chair Jerome Powell’s post-meeting press conference, where policy makers’ characterization of inflation and long-term forecasts for the fed funds target -- the so-called dot plot -- will be critical.

“The high inflation print has put a dent to the peak inflation -- and peak Fed hawkishness narrative,” Mohit Kumar, an interest rate strategist at Jefferies International Ltd, wrote in a note to clients on Monday. “From a Fed perspective, the question is whether they will need to respond even more forcefully with a 75bp at the June meeting.”

The dollar extended gains Monday as the prospect of larger hikes boosted demand for the currency. That put the Bloomberg Dollar Spot Index on course for its best four-day run since March 2020, and just a whisker away from its highest level this year.

Meanwhile, US Treasuries and European bonds fell Monday. The yield on the two-year US note, which is most sensitive to rate hikes, jumped as much as 18 basis points to 3.25%, its highest since December 2007. That saw the curve between two and 10-years invert for the first time since April.

“The combination of collapsing consumer sentiment, unexpectedly intense price pressures and expectations of Fed activism are conspiring to create a particularly toxic cocktail for risky assets,” said Rabobank strategists including Richard McGuire. The yield curve inversion “resonates with the notion that the need to tackle elevated price pressures will see the Fed tip the economy into recession.”

That view is consistent with expectations that the Fed will need to loosen policy again within two years. The market is already positioning for policy makers to respond to the looming slowdown with future rate cuts, pricing two quarter-points of easing by the middle of 2024.