The inversion of the US bond yield curve has been a focal point for investors in recent weeks. An inverted yield curve occurs when short-term interest rates exceed long-term rates. Under normal circumstances, the yield curve is not inverted since debt with longer maturities typically carries higher interest rates than shorter-term debt. An inverted yield curve is a sign that investors are more pessimistic about the long term than the short term. In March, part of the US Treasury curve inverted, when 5-year yields rose above 30-year yields. Importantly the whole curve has not yet inverted, as the crucial 2-year yield still remains below the 30-year yield. Inversions in the yield curve command so much attention, as traditionally it has been a reliable recession predictor. However, research shows that the curve needs to remain inverted for an elongated period of weeks or months. Studies also indicate that a recession definitely isn’t imminent when the yield curve inverts, as it can take anywhere from 12 to 24 months for the economy to contract.

The US economy has experienced a strong rebound since the height of the pandemic. US unemployment is at a historically low rate of 3.6% and high frequency macro-economic data remains positive. However, US annual inflation is currently running at 7.9% and the market is forecasting, in an effort to curb inflation, that the US Federal Reserve will hike interest rates at least 7 times in 2022. The Federal Reserve is clearly prioritising the threat of inflation over any threat to US growth. The latest rhetoric from the Federal Reserve suggests that it believes that any potential recession would be technical in nature (a technical recession is defined as 2 consecutive quarters of negative growth). The market is concerned that an aggressive interest rate path, could be too much and too soon but the Fed is clearly of the opinion that the US economy can withstand the hiking cycle or that the historically low unemployment rate will translate into a soft landing for any rate hiking cycle induced recession.

It is interesting to note, that the yield curve in Europe has not inverted or is not close to inverting any time soon. The European Central Bank has taken a very different approach to the current inflationary spike. The ECB has been consistent in its view, that inflation has been generated as a result of the pandemic. While the conflict in the Ukraine will further stimulate inflation, as economies experience supply side shocks in the form of higher food and energy prices, the ECB believes that inflation will naturally revert towards the 2% target level in 2023 and 2024. The ECB is also constructive on the growth prospects for European economies. Temporary government support measures helped households across Europe navigate the pandemic. Household balance sheets remain in good shape after savings ratios increased to record levels during Covid-induced restrictions. Following the pandemic, these savings will be released into economies as pent-up demand is alleviated, offsetting some of the negative wealth effects from inflation.

As such, investors are forecasting only 2 rate hikes in Europe this year. Market consensus is that the high-point or ‘neutral rate’ of Europe’s hiking cycle will be in the 1%-1.5% area. In contrast, the assumed neutral rate in the US is over 2.5%. While both neutral rates are very low by historical levels, it is the divergence in the pace of interest rate hikes between Europe and the US that is responsible for the difference in the shape of the yield curves.

As investors look towards the summer, attention will remain on the key US 2-year and whether the entire US yield curve inverts or if the curve will remain just partially inverted. Any positive resolution to the geo-political tensions will ease some of the current inflationary fears and help the ECB fulfil its mandate. Focus will remain on the diverging interest rate responses from the Federal Reserve and the ECB. Within globalised economies, it is difficult to see a scenario where both central bank responses are right.

Ryan McGrath is Head of Fixed Income Strategy and Sales at Cantor Fitzgerald Ireland.