Author: William McInnes, originally published in The Australian Financial Review, 25 March 2022.

Markets are divided over the potential for the Federal Reserve and other major central banks to engineer a soft landing, as bond investors begin to price in the risk of recession, while equity investors keep buying.

Global shares have rallied sharply since the Fed decided to raise interest rates this month, acting on confidence that the central bank will be able to rein-in runaway inflation without sending the US economy into recession.

But bond markets appear far less convinced, as investors bet more rate hikes will be needed to control inflation, given US inflation is running at a 40-year-high compelling a hawkish response.

“To have the whole equity market rallying, and especially tech rallying, is just confounding,” said Angus Coote, co-founder and executive director at Jamieson Coote Bonds.

“I think it could be the case that there’s still a buy-the-dip mentality around in equity markets and this could be a dead cat bounce as investors wake up to higher funding costs.”

The difference between the US 10-year Treasury yield and US 2-year Treasury yield is at its narrowest point since March 2020. The 10-year has a yield of 2.37 per cent while the 2-year is at 2.14 per cent, a margin of just 23 basis points.

The inversion of those yields is historically an indicator of recession. The yield curve last inverted in August 2019.

“It’s been a near perfect prediction of recession,” said Mr Coote.

“The bond market is suggesting if the Fed does hike eight or nine times, that does result in bankruptcies and then recession.”

Those alarm bells have not been felt in the equity market. The S&P 500 has climbed 1.3 per cent since the start of the week while the tech-heavy Nasdaq Composite, which is the most sensitive to higher rates, has risen by more than 2 per cent.

“I think it’s a case of being alert but not alarmed at this point,” said Andrew Mitchell, Ophir Asset Management senior portfolio manager. “Skewing towards more defensively orientated businesses that can sustainably grow without paying through the nose for them seems a prudent move to me.”

Economists have been quick to point out hiking cycles rarely end without growth being stalled, a perspective bond investors are sympathetic to.

Capital Economics said since the late 1970s, 13 of the past 16 tightening cycles in the US, UK and Eurozone had ended in recession.

Fed chairman Jerome Powell played down the risk of recession in a speech on Monday.

“The Fed won’t see a 2s 10s inversion” – referring to the 2-year and 10-year bond rates – “as a reason to slow down rate hike... on their measure they have a record level of steepness in their curve to play with before the curve gets to a flat enough level to worry them,” said Jim Reid, Deutsche Bank’s head of global fundamental credit strategy in research published this week.

US Fed boss Powell takes tough stance on inflation

“It’s worth noting that around the time of the last few inversions there was always a chorus of ‘this time is different’.”

Investors say a rise in interest rates could expose a number of “zombie companies”, or businesses that can only survive while the cost of debt is low, even if the hiking cycle does not result in recession.

“About 20 per cent of the Russell 2000 are zombie corporates and their revenues don’t meet their debt obligations,” said Mr Coote.

“They’ve survived because interest rates were falling, but those rates are starting to go higher, some of these businesses will be hitting some serious turbulence and equity markets will wake up to this.”