US treasury yields headed higher throughout last week after various inflation-related data prints showed no signs of impending disinflation.
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US treasury yields headed higher throughout last week after various inflation-related data prints showed no signs of impending disinflation. January CPI (headline: +6.4% YoY, core: +5.6% YoY) came in slightly higher than expected while January PPI (headline: +6% YoY, core: +5.4% YoY) rose +0.7% MoM against expectations of +0.4% MoM. Additionally, data on Friday showed export prices rose +0.8% YoY versus expectations for a 0.2% YoY decline. Federal Reserve (Fed) speakers were generally hawkish, too.
Looking forward, we believe a 25 to 50bp increase in the terminal federal funds rate (FFR) in the March SEP is likely. And with unemployment at 50-year lows, potentials for upsides to wage growth and services inflation exist. Dominique believes a 50bp hike at the March FOMC meeting would be back on the table, should we see continued strong prints at the next round of CPI and NFP release. This week, we get FOMC minutes, more Fed speakers (Dominique expects their tone to be hawkish), and PCE data on Friday (Dominique agrees with the consensus of expectations of +0.4% MoM for core).
Turning to market moves, US 10Y yields closed the week at 3.82% (+8bps WoW) compared to 4.60% (+10bps WoW) for the 2Y and 4.70% (+4bps WoW) for the 3M. The magnitude of the 2s10s inversion deepened to -83bps on Tuesday before closing the week at -78bps on Friday. The magnitude of the 3M10Y inversion is -88bps. The probability of recession increases with yield curve inversion.
Our recession model, which uses the 2Y10Y part of the yield curve, assigns an 90% chance of a recession within the next twelve months (Charts 1 and 3). Meanwhile, the Fed recession model, which uses the 3M10Y part of the yield curve, produces a 52% chance of recession (Chart 2). Notably, both models are producing recession probabilities higher than that of the 2007-2008 Global Financial Crisis (GFC).
Background to Models
We introduced two models for predicting US recessions using the slope of the US yield curve. When long-term yields start to fall towards or below short-term yields, the curve flattens or inverts. This has often predicted a recession in subsequent months. Our model is based on the 2s10s curve compared to a model from the Fed that is based on 3M10Y curve. We believe that the 2Y better captures expectations for Fed hikes in coming years and is therefore more forward-looking.