Wall Street’s favorite recession indicator is flashing red

A closely watched recession predictor in the bond market just flashed red, spurring fresh concern that the US economy is on track for a downturn this year as a result of the Federal Reserve’s war on inflation.

The spread between the 2-year and 10-year Treasury yields inverted this week for the first time since April on fears that the Federal Reserve’s aggressive approach to tackling the hottest inflation in four decades could lead to a sustained slowdown in growth. The phenomenon – which is rare – has been a historically accurate predictor of recessions. 

Yields on the 2-year Treasury note climbed as high as 3.431% during morning trading on Tuesday, rising above those on 30-year bonds, which fell to about 3.277%. The movement reflects “fears of a Fed policy error and an impending recession,” according to Mark Hackett, chief of investment research at Nationwide.

Yield curve inversions are viewed as a good recession predictor because it suggests that investors believe – with the interest rate on long-term bonds lower than the rate on short-term bonds – economic growth is slowing. Every recession in the past 60 years was preceded by an inverted yield curve, according to research from the Federal Reserve Bank of San Francisco.

There are growing fears on Wall Street that the US central bank will trigger a downturn as it raises interest rates at the fastest pace in two decades following a scorching-hot Labor Department report released last week that showed the consumer price index rose 8.6% in May from a year ago, faster than expected. It marks the fastest pace of inflation since December 1981.

The dismal inflation report unnerved investors and prompted traders to revise their expectations for Fed rate hikes this year. Wall Street banks Barclays and Jeffries are now forecasting a 75-basis point hike – the first since 1994 – at the conclusion of the Fed’s policy-setting meeting on Wednesday. A majority of traders – about 96% – have also penciled in a mega-sized rate increase this month, according to the CME Group’s FedWatch tool, which tracks trading.

 “The US central bank now has good reason to surprise markets by hiking more aggressively than expected in June,” the Barclays strategists wrote in a note Friday. “We realize it is a close call and that it could play out in either June or July. But we are changing our forecast to call for a 75-basis point hike on June 15.”