A US economy without recession? What are the bond markets sending?

Financial markets are seeing renewed interest as expectations grow that the U.S. economy may avoid a recession, contrary to expectations.

According to a recent analysis by Deutsche Bank, there is a possibility that the yield on the 10-year Treasury bond could rise from the current 3.84% to 4.1%, which is interpreted as a signal that the U.S. economy could be stronger than the market expects, MarketWatch reported on the 27th (local time).

◇ Unexpected bullish signal

Deutsche Bank’s analysis suggests that the U.S. economy may be stronger than expected, possibly due to a gap between current economic data and market expectations.

First, looking at the labor market situation, the number of unemployment benefit claims continues to decrease. This means that the job market is still strong. Usually, during a recession, the unemployment rate rises and unemployment benefit claims increase, but the current situation is the opposite.

At the same time, financial markets have already priced in a significant portion of the Fed’s rate cuts. Investors expect at least one rate cut at the three remaining Fed meetings this year, reflecting expectations that the economy will slow and the Fed will have to lower rates.

◇ Warning sound from the bond market

Deutsche Bank believes that these market expectations may not be in line with the current economic situation, with the labor market still strong, meaning the Fed may not need to cut rates as quickly or as much as expected.

Based on this analysis, Deutsche Bank forecasts that the 10-year Treasury yield could rise from the current 3.84% to 4.1%. Rising Treasury yields generally reflect a positive outlook for economic growth. That is, if the economy is stronger than expected, investors will demand higher yields, which will lead to lower Treasury prices (higher yields).

This outlook is somewhat contrary to the current market consensus that a recession is imminent. Therefore, future economic indicators and the Fed’s policy decisions should be given more attention.

In addition, the term premium is currently at its lowest point since the beginning of the year, and is structurally too low considering changes in supply and demand. This means that there is room for long-term bond yields to rise.

Term premium refers to the additional return that investors expect from holding long-term bonds. Long-term bonds generally carry higher risk than short-term bonds, so investors demand additional returns as compensation.

According to Deutsche Bank’s analysis, the term premium is currently at a very low level compared to the beginning of the year. This means that investors are not demanding sufficient additional returns for long-term bonds. In addition, considering the changes in demand and supply in the bond market, it is difficult to see this low term premium continuing structurally.

This suggests that long-term bond yields are likely to rise in the future. As investors begin to demand adequate compensation for long-term bonds, bond prices will fall and yields will rise. This is consistent with the previously mentioned outlook for rising 10-year Treasury yields.

The background to this analysis is the question of the Fed’s ‘soft landing’ scenario. It is noteworthy that Fed Chairman Powell recently mentioned in his Jackson Hole speech that he would not welcome a worsening labor market. This is a somewhat different position from the existing expectation that the Fed would tolerate a recession to suppress inflation. This change in the Fed’s perception is a factor that could increase uncertainty about future interest rate policy and economic outlook, and increase volatility in the bond market.

◇ Impact on financial markets and responses

If this outlook becomes a reality, the impact on the financial market will be significant. The rise in government bond yields could have a negative impact on the stock market. In particular, growth stocks and technology stocks may become less attractive for investment. On the other hand, it could have a positive impact on financial stocks such as banks.

It could also affect the real estate market, as it could lead to higher mortgage rates. It could also increase the cost of financing for businesses, which could affect overall economic activity.

Investors can adjust their portfolios to prepare for such situations, increasing the proportion of short-term bonds in an environment of rising interest rates to reduce risk. In addition, it is necessary to pay attention to sectors such as finance, energy, and materials that can show relative strength in an environment of rising interest rates. In particular, it is also possible to prepare for the possibility of a strong dollar. Rising U.S. interest rates can lead to a strong dollar, so it is important to manage exchange rate risk accordingly.

Finally, we should pay more attention to economic indicators. In particular, employment and inflation data should be closely monitored as they have a significant impact on the Fed’s policy decisions.

The current market is experiencing increasing uncertainty in the financial market as the possibility of a ‘soft landing’ for the U.S. economy is raised. The possibility of a ‘soft landing’ is an overall positive scenario, but it is different from existing market expectations and may increase uncertainty in the short term.

This can be seen as a phenomenon that occurs as the market seeks a new equilibrium point, and investors should pay more attention to risk management in preparation for such changes, while also making efforts to find new investment opportunities.

Park Jeong-han, Global Economic Reporter park@g-enews.com