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Will Bonds Signal Inflation, Recession, or Stagflation?

Talks about recession have increased steadily in recent weeks. It is partly because of fears of escalating inflation pressures and concerns about a policy mistake by the central bank. Also, the inversion of the US bond yield curve, namely the 10-year minus the 2-year yields earlier in the year, is a shot across the bow warning of an impending economic slowdown.


The press and media have also begun to report on the prospects of stagflation. Stagflation is a rare economic phenomenon when an economy experiences slow or stagnant growth and high inflation. Stagflation became synonymous with the 1970s to early-1980s as the OPEC oil embargo resulted in soaring oil and energy prices. The sharp jump in commodity prices, wage-price spirals, high unemployment, and stagnant economic growth lead to a decade-long stagflation economic cycle.


Although we currently have an energy shock due to the Russia/Ukraine war, the supply restraints and bottlenecks issues from the Covid-19 pandemic, the unprecedented global lockdowns, and the global reopening are the primary reasons for today’s inflationary pressures.


While inflation will likely continue as long as demand for goods and services outweighs supply, the probability of a recession and stagflation remains a more significant issue, especially in Europe. European countries are most vulnerable to stagnant growth and continued high inflation.


Since soft assets such as stocks and bonds discount economic conditions months and quarters ahead of pivotal turns in economic cycles, studying bonds can offer insights into inflation, recession, or stagflation cycles.

Historically, bonds are most sensitive to structural forces such as economic conditions. Interest rates turn well in advance of the onsets of inflations and recessions.


Can bonds be a reliable leading indicator of economic conditions when inflations and recessions are economically opposites? If you believe in mean reversion or regression to the mean, economic cycles will repeat over time. Rising inflation will subsequently trigger a recession, and in turn, a recession can bottom as inflationary pressures subside, and this cycle again repeats itself.


Persistent and long-term inflationary pressures tend to erode the value of stocks, but more so with bonds. Since bond traders are conservative and are risk-averse, they are likely to sell bonds at the first signs of rising inflation.


Since bond prices and yields are inversely correlated, the selling of bonds leads to rising yields, as denoted by the 10-year US treasury yields (TNX) and the 30-year treasury yields (TYX) soaring this year. Interestingly, both long-term maturities have faded as they near their 40-year structural downtrends at 3.00-3.25% and 3.25-3.50%, respectively.


It may be a coincidence, but TNX and TYX struggling to breakout above structural resistances hint of inflationary forces peaking or abating. Another explanation for why interest rates may be peaking is investors may be turning to the safety of US government bonds in anticipation of an economic slowdown or contraction.


Technically speaking, the 50-day and 200-day moving averages continue to trend higher for US treasury yields at 2.613% and 1.827% for TNX and 2.755% and 2.195% for TYX. It may be too premature to confirm a structural top in US interest rates. However, if TNX repeatedly fails to clear above 3.00-3.25% and declines below 2.61%. At the same time, TYX struggles to close above 3.25-3.50% and falls decisively below 2.75%, signaling a trend reversal, at least from a near-to-intermediate-term basis. Nonetheless, convincing monthly closes below the 200-day moving averages at 1.83% (TNX) and 2.19% (TYX) are still needed to solidify longer-term trend reversals toward much lower yields.


Bond markets are currently flashing warning signs about slowing growth rates as central bankers implement tightening policies to fight soaring inflation. Compression in spreads between the long-term and short-term government bonds also warns of a weaker economy.


Will TNX and TYX break down below their respective moving averages?


Will the Fed engineer a soft landing for the economy?


Directional trend changes in yields have significant repercussions for financial markets, including the directions of stocks, currencies, and commodities.


Source: Chart courtesy of StockCharts.com

Source: Chart courtesy of StockCharts.com

Source: Chart courtesy of StockCharts.com

Source: Chart courtesy of StockCharts.com


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