Recession, Inflation – What’s the Market View?

The economy is still likely to grow, according to at least the 10yr-3mo spread. Less definitive indicator from the 10yr-2yr. Expected inflation rates have stopped moving up, and so too have implied future rates 2-3 months ahead; in fact they’ve both fallen in recent days. (For what analysis, rather than markets, think about inflation, see Jim’s Monday post; on recession, see Jim’s Wednesday post.

Figure1: Ten year – three month Treasury spread (blue), and ten year – two year Treasury spread (red), in %. NBER defined recession dates shaded gray. Source: Treasury via FRED, NBER, and author’s calculations.

What does expected inflation look like, and how are interest rates seen as moving in response?

Figure 2: Five year inflation breakeven calculated as five year Treasury yield minus five year TIPS yield (dark blue, left scale), five year breakeven adjusted by inflation risk premium and liquidity premium per DKW (light blue, left scale), 2-3 months forward interest rates (brown, right scale), all in %. NBER defined recession dates shaded gray. Source: FRB via FRED, Treasury, Kim, Walsh and Wei (2019) following D’amico, Kim and Wei (DKW), NBER.

It’s hard to see how the 5 year inflation breakeven is evolving, but it’s stopped rising, as oil price have retreated.

Figure 3: Five year inflation breakeven calculated as five year Treasury yield minus five year TIPS yield, % (blue, left scale), and price of oil, WTI, $/bbl (black, right log scale). Source: Treasury and EIA via FRED.

Interestingly, as the Fed funds rate was increased, the 2-3 months forward interest rate decreased (although this could be because of the fall in oil prices).

Figure 4: Fed funds rate (red), one month Treasury yield  (black), 2-3 months forward interest rates (brown), all in %.  Source: FRB via FRED, Treasury, Kim, Walsh and Wei (2019) following D’amico, Kim and Wei (DKW).

Jim presents his overview of “Sanctions, energy prices, and the world economy” in this video.