Bond Traders Expecting Inflation to Plummet in 2023

A trader works on the floor of the New York Stock Exchange in New York City. Mario Tama/Getty Images/File Photo

U.S. inflation is set to decline next year, according to activity in the bond market, with the gap between the two-year and 10-year Treasury yields trading at its most negative level in decades.

The gap between one-year Treasury inflation-protected securities and similar-dated nominal government notes is at 2.18 percent, indicating that average inflation over the coming year would be roughly around this level. Considering that the annual inflation came in at 7.1 percent in November, this would require price gains to drop by roughly 5 percent in the coming year.

Such a fast pace of decline has only been seen three times in the past 60 years, with every single one occurring during or just after a recession, according to a Bloomberg analysis.

The 10-year Treasury yield is lagging behind the two-year Treasury yield by the widest margin since the early 1980s. Last week, it hit a new extreme of 85 basis points. The wide margin between the two yields is often seen as a reliable indicator of recession.

“Headline inflation is peaking, and market participants appear keen to look forward, and remain on the lookout for signs that monthly inflation momentum has peaked,” said Andrew Ticehurst, a rates strategist at Nomura Holdings Inc. in Sydney, according to the outlet. “Lower breakeven rates could also be signaling increasing concern regarding the possibility of recession.”

Meanwhile, the CBOE Volatility Index (VIX), the stock market’s fear gauge, settled below the 20 level on Dec. 2, the first time since October. VIX usually tends to rise as stocks decline.

According to a report by S&P Global, the fall in VIX is a reflection of “changing hedging strategies” as institutional investors dump equities and traders try to protect their investments from rapid economic developments. It can also indicate that the index has hit its peak in the near-term.

“Ultimately, the VIX just shows the sentiment of traders, and when that sentiment is overly benign, as we’re seeing now, it has tended to signal that we’re on the verge of a top forming,” said Matthew Weller, global head of research with Forex.com and City Index, according to the report.

Inflation and Recession

During a recent interview with CNN, Ken Rogoff, former chief economist at the International Monetary Fund, said that the window to avoid a recession while bringing down inflation was becoming narrower. He believes that the odds of the U.S. economy slipping into a recession are “very high.”

“The economy’s very strong, but it’s unsustainable. The inflation’s too high. The Fed’s going to keep raising interest rates. And you mentioned China earlier, looking at what’s going on in Europe. The whole world’s sinking into recession. It’s hard for us to stay out of it.”

During a CNBC interview, Jason Furman, who served as chairman of the Council of Economic Advisers under President Barack Obama, predicted the most likely economic scenario for the United States will be a mild recession that does not solve inflation. A recession that solves inflation only has a 10 percent chance of happening, he said.

The Conference Board Leading Economic Index (LEI), a key economic gauge, dropped for the eighth straight month in October, suggesting that the American economy is likely in a recession.

The Conference Board forecasts real GDP growth to be just 1.8 percent in 2022, with a recession potentially starting around the end of this year and lasting through the middle of 2023.