The United States could see a sharp decline in inflation without entering a recession, Bank of America said.
Strategists pointed to the inverted Treasury yield curve, the bond market’s notorious recession gauge.
But this time around, the indicator signals a hard landing for inflation, not the economy.
Inflation could be heading for a sharp decline and prices could drop significantly without the United States having to face a recession, according to Bank of America.
Strategists pointed to the inverted 2-year and 10-year Treasury yield curve, the notorious bond market recession indicator that has successfully predicted many downturns, most recently in 1990, 2001 and 2008. When short-term yields exceed those of long-term bonds, it has always signaled to investors that a downturn is coming.
The difference between 2-year and 10-year Treasury yields widened by one percentage point last week, marking the steepest reversal in more than 40 years.
This time around, however, the indicator is more reflective of a hard landing in inflation, the bank said, and the U.S. economy is likely to avoid a sharp slowdown yet again.
“While the inversion of the curve and historical extremes have generated higher probabilities of recession from the models, we believe that the shape of the curve is more a function of expectations of lower inflation than a deterioration in growth,” the strategists said in a note on Thursday. “A look under the hood suggests that real forward rates don’t factor in elevated recession risk and may instead reflect expectations of a soft landing relative to consensus.”
Indeed, real forward yields, which represent market expectations for inflation-adjusted bond yields, saw only a “modest decline” in the near term, the bank said.
This suggests that investors expect the Federal Reserve to slowly cut interest rates, which they are unlikely to do if the economy faces particularly high recession risk.
“The inversion of the curve at historically extreme levels does not currently reflect elevated recession risk, but rather is largely tied to expectations of cuts alongside inflation converging towards target,” the strategists added, referring to the Fed’s 2% inflation target.
Investors have been eyeing a potential recession for a year as the Fed raised interest rates aggressively to rein in inflation, a move that threatens to tip the economy into recession.
Rates are now at their highest level since 2007, with Fed officials suggesting more hikes are coming later this year. Markets are pricing in an 87% chance the Fed will hike rates another 25 basis points at its July policy meeting, a move that would take the fed funds rate target to 5.25-5, 5%.
The New York Fed, meanwhile, has put a 71% chance that the economy will slip into recession by next year.
Read the original article on Business Insider