Uncertainty over the business cycle, a more restrictive monetary policy and the impasse over raising the nation’s debt ceiling are spurring a classic migration to the preferred habitat of spooked investors: risk-free securities.
With the U.S. two-year yield now exceeding 5% and the Federal Reserve’s repo facility offering a return of 4.5%, capital is flowing into short-term securities in search of safety and yield rather than into more productive longer-term investment.
Investors are attracted to the yield on short-term paper, which is paying roughly 100 basis points more than comparative long-term paper.
The shift is reflection of a changed outlook in the market, which is now pricing in a hard landing to the economy as the Federal Reserve lifts its policy rate to a minimum of 5.5% and possibly to 6% by the middle of the year.
Consider the returns from the S&P 500 index: It has lost nearly 15% of its value on an annualized basis since the end of 2021.
Now, compare that with the yield on the five-year Treasury. After yielding an average of 3.1% since the beginning of last year, the five-year yield has surged to 4.25%. Already, that has led a substantial segment of investors to think twice about the makeup of their portfolios.
Corporate debt
That flight to safety follows a plunge in the issuance of corporate debt last year, even though real interest rates were negative.
We see this reluctance among businesses to take on debt as an indication of caution because of rising credit costs and the potential drop in demand and revenue if the economy slows substantially.
The decrease in corporate issuance implies that banks and financial entities are holding an abundance of cash reserves that need to be invested.
One can observe this through the increase in collateral parked in the Federal Reserve’s repo and reverse repo facility.
Use of the facility is three times higher than in June 2021 and is now offering a 4.55% so-called reward rate, matching the increases in the federal funds rate.
More than $2.1 trillion in capital is sitting on account inside the central bank’s repo facility.
Despite the resilience of demand in the economy and the persistence of inflation, the bond market has given ample reason to think the economy will at some point respond to the Fed’s tightening of financial conditions.
The shape of the yield curve has in past business cycles predicted the onset of recessions, which makes investors track its movements intensely.
In recent days, the yield on two-year Treasury bonds has broken above 5% while 10-year yields remain just below 4%. The last time this spread was 100 basis points was in the 1980s, during the double-dip recession, which brought the world economies to their knees.
The takeaway
But that’s not to say that this time won’t be different. The circumstances of this business cycle are unlike the others. There are many reasons why the yield curve inversion may not mean recession, including the size of the Fed’s balance sheet, a real federal funds rate at roughly zero and structural changes to how financial markets and the economy operate.
But unless the flow of cash into the short end of the curve abates, firms and consumers will soon follow signaling a potential end to the current business cycle.
