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An under-the-radar recession indicator in the bond market is raising alarm that the economy could be heading for a hard landing, according to ING Economics.
Strategists at the analytics firm pointed to a tight correlation between US Treasury yields and Bund yields in Europe, with both yields slipping in recent weeks as markets reprice their interest rate expectations over the short-run.
After the European Central Bank noted European wages slowed over the fourth quarter, the 2-year Bund yield ticked slightly lower on Tuesday, trading around 2.77%. Meanwhile, the US 2-year Treasury slumped around 7 basis points, trading around 4.59% Wednesday morning.
When Treasury and Bund yields are highly correlated, that's a sign that the US economy could be poised to enter a recession, ING said, as European central bankers are looking to cut interest rates quickly if the US tips into a downturn.
That was the case in the Silicon Valley Bank crisis in early 2023, when a sell-off fueled by the collapse of SVB led Treasury yields and Bund yields to tumble in tandem.
"The correlation between UST and Bund yields is significantly elevated, which usually points to a hard-landing narrative," strategists said in a note on Wednesday. "In the case of a US hard landing, such as a severe recession or something 'breaking,' the ECB would also be inclined to react with short notice."
But US investors remain bullish on markets and the economy, especially since the Fed is expected to cut interest rates later this year. Central bankers have projected 75 basis points of rate cuts by the end of 2024. Investors are looking for an even steeper pace of easing, with a 60% chance priced in that the Fed could lower rates at least a full percentage point by December, according to the CME FedWatch tool — something that would indicate a soft-landing is in the cards, ING said.
"As such, we would expect the tight correlation to weaken going forward, allowing euro markets to increase their focus on the ECB's narrative as opposed to the Fed's," strategists added.
Economists, though, have warned recession risks are still alive as the labor market looks poised to weaken. Rates, meanwhile, could stay higher-for-longer than investors are anticipating as inflation pressures linger in the economy, which raises the risk that the Fed overtightens the economy into a downturn.
The US now has an 85% chance of entering a recession, the highest probability seen since the Great Financial Crisis, according to one economic model. New York Fed economists, meanwhile, are pricing in a 61% chance the economy could tip into recession by January of next year.
