Yield curve: Imminent recession is ‘far from a certainty,’ strategist says

Janney Chief Fixed Income Strategist Guy LeBas joins Yahoo Finance Live to discuss Fed policy ahead of the FOMC meeting as well as the outlook for a possible recession.

Video Transcript

BRIAN CHEUNG: Welcome back to Yahoo Finance Live. We're taking a look at bond yields on this Wednesday morning, as we take a look at the US 10-year, for example, right now at 2.18%, up about two basis points. The 30-year on the longer end of the curve down two basis points to 2.49%. Rising yields have been the story for the last week, really, for the entire year. And if we take a look at our chart of the day, a big reason is because of expectations that the Fed will have to hit the brakes with rising inflation.

What you're looking at here is the difference between the two-year and the 10-year. And this is important because when this measure dips below zero, that has historically preceded a recession. And you can see that we're getting pretty close as the Fed embarks on its ambitious effort to try to raise interest rates. But here's the other thing, right? There are other measures of the yield curve that are flashing different signals. So if you take a look at the blue line, which we've added here, this is a different measure. It's still the 10-year, but we're comparing it against the three-month shorter duration Treasury.

And that is showing that we're really not close to zero, which raises the question, Emily, I mean, how close are we to recession? We know anecdotally, there's a lot of storylines here with COVID and with the Russia-Ukraine crisis and just with the history of the Fed not being able to tighten without inducing a recession, kind of entering into the fold as well.

EMILY MCCORMICK: That's right, Brian. A lot of uncertainty here. Of course, mentions of the R word, recession, have really risen in the past couple of weeks now, coupled with the geopolitical turmoil we have between Russia and Ukraine. But I do want to highlight a note that I received from Deutsche Bank earlier today. And what they mentioned is that not every Fed hiking cycle leads to a recession, but all hiking cycles that invert the curve have led to recessions within one to three years.

Now that is going to be something to watch here. We're still awaiting potentially that yield curve inversion that may start that timeline. But again, this is going to be something to watch here as we get, again, those summaries of economic projections, those new dots from the Fed today to see what they're expecting, and also to see whether the Fed's policies are ultimately going to be able to bring down inflation, currently running at about a 40-year high now, while also leaving economic activity intact.

BRIAN CHEUNG: Yeah, a lot of lingering questions for sure, but let's get some insight from an expert in this space. Guy Lebas is Janney chief fixed income strategist and joins us live now on the show. It's great to have you on the program. And we were just talking about kind of how yields are messaging what could be coming down the pike from the Fed. I guess, you've noted that there have been 11 rate hike cycles, the 12th of which is going to begin today. Not all of those have succeeded in avoiding a recession. So what's your forecast for how the Fed's going to get out of this?

GUY LEBAS: Yeah, so they're going to get out of this by raising interest rates and reducing the size of their balance sheet, essentially tightening policy in aggregate to aim-- for the main aim of reducing inflation. Supporting economic growth, while certainly important, is the secondary goal at this point. You know, there is a phrase that I've frequently used near the beginning of Fed rate hike cycles, particularly as the yield curve is flattened, which is that yield curve inversions have predicted 10 of the last seven recessions. I think I might have stolen that from Paul Samuelson.

But the reality is while they provide a signal on the probability of economic slowing, they're far from a certainty. In addition, while the yield curve is relatively flat, this is actually not the flattest it's ever been at the beginning of a hiking cycle. Using the twos to 10, the two-year Treasury to a 10-year Treasury yield as just a benchmark measure of the shape of the yield curve, the curve was actually flatter when we began the hiking cycle in 1999. So it's been a while, but we've been there before. And at this point, there's not a very high probability in the models that we run for a recession within an 18-month period.

EMILY MCCORMICK: So Guy, if the yield curve right now is perhaps not signaling an imminent recession at this point, what do you think Treasury yields and the shape of the curve right now is telling us?

GUY LEBAS: Well, essentially, it's telling us that economic activity is likely-- and inflation, in particular, is likely to slow relatively soon after the Federal Reserve begins hiking interest rates, which is what we might expect, right? There's a lot of reasons in particular why inflation is likely to slow.

But typically, the shape of the yield curve is, particularly from the overnight point to about the two to three-year point, it's really a function of the expected path of the Fed funds curve. And essentially, the markets are anticipating a series of short rate hikes, followed by a stop and a wait and see, which is a reasonable approach. That said, my implicit bet essentially is that the Federal Reserve will manage to hike fewer times than the markets have currently priced in.

BRIAN CHEUNG: Well, Guy, that raises an interesting point because there is kind of a disparity between where markets are pricing the amount of Fed rate hikes we should expect to see this year and what the Fed might telegraph when they release their dot plot projections later on today. So markets seem to expect more rate hikes than perhaps what the Fed is going to telegraph. How do you square those two things together?

GUY LEBAS: Well, the market has always had a different opinion than the dot plot. If you take a look at the forward implied interest rate from something called the OIS curve, it's varied from what the dot plot suggests by a wide margin, particularly when we're approaching the chance of cutting, granted we're a couple of years away from that at this point.

But the Federal Reserve forecasts are-- the dots are not created equal, right? Some dots carry more weight than others. For example, Jay Powell, Christopher Waller, other members of the Fed board who will be permanent voters in the FOMC, their dots-- but we can't necessarily pick them out from the rest-- carry more weight. And so I think the pricing is more likely to sniff out what those dots represent, rather than the aggregate.

I also point out one other thing, which is that by virtue of Jay Powell wanting to maintain flexibility, as he calls it, in the forward interest rate path, that's going to naturally lead to a market, which will, in almost every circumstance, price in more rate hikes than are likely to occur, because you've got a price-- the chance that that flexibility will need it, even if realistically, it doesn't come to pass.

EMILY MCCORMICK: All right, we'll leave it there for now. Guy Lebas, Janney chief fixed income strategist, thank you again so much.