The Yield Curve Will Fully Invert When China’s Covid Lockdowns Pressure Supply Chains

April 8, 2022

(Bloomberg) — A massive knock to the Caixin China Services Purchasing Managers Index in March shows that the latest virus outbreak is taking a toll on growth. But it’s the Federal Reserve’s incipient rate hike campaign that will have the most impact on supply-chain problems and inflation, and thus on global markets.

Most Read from Bloomberg

If China continues its Covid-zero approach, expect global supply chains to remain stretched, U.S. inflation to remain elevated and for the Fed to be forced belatedly into jumbo rate hikes. That would put tremendous flattening pressure on the Treasury curve out to three years.

We’ve known for more than three months now that omicron would eventually hit China hard, and that China’s reaction could be key for inflation in 2022. The negative shock of a composite PMI print at 43.9 tells us that the growth impact is already there. Both the overall index and the forward-looking new orders subcomponent were at February 2020 lows.

The problem now, however, is that we could see supply-chain disruptions from China’s lockdowns just as U.S. 2021 inflation data base effects are about to kick in, which would have lowered 2022 inflation prints. Chinese officials understand this problem and are attempting to keep normal port and shipping operations despite the case numbers in Shanghai. The risk is that they fail.

All recent Fedspeak — from Patrick Harker to Mary Daly to Jerome Powell to Lael Brainard to Esther George — has focused on the optionality between 25- and 50-basis point moves, depending on how inflation develops. They’re “open” to moving by 50 basis points in May. But none of them has said they’ve penciled that in. Philadelphia Fed President Harker was the median dot in March and he wants a train of 25-basis-point hikes, as has been the norm for two decades. But the Chinese lockdown situation could change that calculus.

Right now, the consensus represented by a steep yield curve out to three years and complete inversion to 10 is one where the Fed raises rates precipitously, but is then forced to unwind that tightening due to rapid economic deceleration. China’s Covid situation makes that outcome more likely. And as the Fed moves to jumbo hikes, it means that the next curve inversion to expect is in the two-year versus the three-year, now at about 20 basis points, as the Fed is forced to tighten. That would make the curve completely inverted from two to 10 years, and would invert the two-year versus the 10-year spread for more than just a few days. That’s when a true recession signal cannot be ignored. Look at the two-year versus the five-year, now at about 20 basis points, as a proxy for that signal.

NOTE: This was a post on Bloomberg’s Markets Live blog. The observations are those of the blogger and not intended as investment advice. For more markets analysis, go to MLIV.