Fixed Income Viewpoints: Is the Bond Market Priced for Perfection?

The Viewpoints series gives investors Lazard’s perspectives on the latest macroeconomic and fixed income news and trends. In this edition, Lazard Asset Management's fixed income team examine the surprising recent inversion of the U.S and European yield curve, and what it may mean for the prospects of a soft landing for the U.S. economy.

Waves of good news on the U.S. economy — showing it was not too hot and not too cold — helped drive a relentless rally in U.S. Treasury bonds over the past month, culminating in what appeared to be the official end to the Federal Reserve’s rate-hike cycle.

Following its meeting in mid-December, the Federal Open Markets Committee (FOMC) left interest rates unchanged and released its new policy-rate projections, or “dot plot,” revealing that members expected no more rate hikes and three rate cuts in 2024. The “pivot” added fuel to the rally that began in late October and sent the benchmark 10-year yield below 4.0% — a plunge of more than 110 basis points (bps) over that time.

The Fed’s news fit well into the market’s predominant narrative that the economy would achieve a soft landing. Reflecting this view, the 10-year inflation expectation (breakeven) rate dropped to an impressive 2.2% by December, only slightly more than the Fed’s inflation target of 2%.

Amid all the positive news, however, came one surprising development: The inversion of U.S. and European yield curves increased during the bond rally — and yield curve inversion has historically been a precursor to recession. The difference, or spread, between 2-year and 10-year U.S. Treasury yields, which had reached a recent peak of nearly -15 bps in October, slid back to more than -50 bps by mid-December. The inversion between 3-month and 10-year yields was even greater, at more than -140 bps.

When Lazard’s fixed income professionals met this month, increased inversion of the yield curve served as a reminder that a recession in the United States is still possible — even as much of the bond market looked “priced for perfection,” in their view. In fact, nine out of the past 12 Fed rate-hike cycles ended in recessions, our analysts observed; out of the three cycles that did not, two involved preemptive tightening by the Fed, unlike the latest round.

Click here to read the December issue of Fixed Income Viewpoints.