**A Recession Could Turn Treasury Bulls Into Bears as Fiscal Risk, Inflation Expectations Loom**
A recession typically brings relief to bond investors. Historically, yields decline as inflation cools and central banks shift to more accommodative policies. However, the present economic landscape presents a different risk: any downturn could lead to only a short-term dip in yields, followed by renewed upward pressure driven by increased government spending and heightened inflation expectations.
This emerging paradox raises a warning for fixed-income markets: Treasury bulls may find their optimism short-lived if a recession sparks another wave of fiscal expansion and stimulus measures.
**Lessons from 2020–2021**
The U.S. experience during 2020 and 2021 offers a cautionary tale. In response to the COVID-19 pandemic, trillions of dollars in stimulus spending—including direct relief payments and emergency support programs—were pumped into the economy. This move facilitated the sharpest inflation spike since the early 1980s.
Although a supply shock like the one seen during the pandemic may be unlikely in the near future, another economic downturn could prompt a similar policy response. In an era of already significant federal deficits, future fiscal support—whether in the form of subsidies, tax breaks, or direct payments—could reignite inflation expectations and drive long-term yields higher. In this sense, the bond market’s reaction to recessions may be shaped more by fiscal strategy than by traditional monetary policy.
**TIPS vs. Nominal Treasuries: A Case Study**
The inflationary trends of the past few years are also reflected in the performance of Treasury Inflation-Protected Securities (TIPS) relative to nominal Treasuries.
Consider the five-year TIPS issued in October 2020 (CUSIP 91282CAQ4) and the comparable nominal Treasury bond (CUSIP 91282CAT8). At issuance, the breakeven inflation rate—the difference between nominal and TIPS yields—was 1.65%. In theory, both securities should have delivered similar total returns if that inflation expectation had proven correct. However, actual inflation over the 2020–2025 period averaged 4.43%—almost three percentage points higher than forecast. As a result, the TIPS yielded approximately 3.11%, vastly outperforming the nominal bond’s return of just 0.33%.
Investors who anticipated the inflationary effects of aggressive fiscal policy were significantly rewarded.
**Today’s Inflation Debate**
Currently, the yield on five-year nominal Treasuries is around 3.65%, while five-year TIPS yield about 1.15%, suggesting the market expects inflation to average 2.50% over the next five years. Forecasts vary: the University of Michigan’s consumer survey places expectations at 3.70%, the New York Fed at 2.90%, the Cleveland Fed at 2.32%, and the Federal Open Market Committee (FOMC) targets a long-run average of 2.00%.
For investors, the decision is clear-cut. Those expecting inflation to exceed 2.5% in the near future would favor TIPS, while those anticipating a return to pre-pandemic inflation norms may find nominal Treasuries more attractive.
**The Structural Fiscal Backdrop**
While recessions typically bring disinflation, the current fiscal environment adds complexity. With federal deficits running above 6% of GDP and limited political appetite for austerity, real interest rates may not fall as sharply as in previous downturns. Investors must factor in whether a future recession might deliver another inflationary wave—not because of supply shocks, but due to demand-driven fiscal stimulus.
**Looking Forward**
Markets currently assume that inflation will settle back into the 2%–2.5% range. However, the post-2020 period has demonstrated how quickly those assumptions can be upended. If another recession leads to significant fiscal expansion or a repricing of inflation risk, TIPS could again outperform nominal Treasuries. What may initially appear to be a safe-haven bond rally could evolve into a renewed challenge for market stability.
In an era where fiscal dynamics increasingly shape market outcomes, investors in government debt should remain alert—not only to economic data and Fed policy, but to the political and structural forces that influence long-term inflation and yields.
