Economy

Column-Fed may be alert for favoured yield curve alarm by Mike Dolan By Stocksak



By Mike Dolan

LONDON (Stocksak). – The U.S. Federal Reserve tends not to tighten until something breaks, which some investors believe despite denials by the central bank, then it might have felt an unnerving crunch.

The Fed’s favorite bond market measure of a possible recession has cracked.

The Fed has raced this year to increase interest rates to counter an inflation spike caused by a Russia related energy shock. They will do it again next week. There has been no shortage in financial turbulence, market liquidity worries, domestic housing stress, and dollar-related pressures in the interim.

Despite endless handwringing about whether the monetary squeeze would lead to a recession, U.S. economy growth was fairly resilient through the third quarter and the labour market is still quite robust.

Despite the obvious angst it’s not the kind of ‘pain Fed chair Jerome Powell thought might be necessary to bring inflation back down to target. The latest monthly readings of core inflation were not encouraging.

Despite the fact that the current corporate earnings season has been bumpy, consensus economic forecasts have not been too optimistic. The U.S. economic “surprises” are still in positive territory.

The markets insistently believe that the Fed is going to slow down the pace of its jumbo 75 base point interest rate rises, even though it delivered a fourth straight increase of that magnitude next Wednesday.

Futures now predict a smaller 50 bp increase in December. The implied Fed ‘terminal’ rate next year has fallen by about 25% to 4.8% over the past week. Speculation was fueled by a decrease in the Bank of Canada’s rate hike pace this week.

Ten-year Treasury yields are down 40 bps from last Friday, while the U.S. dollar has fallen off the boil. Even with some troubling corporate health warnings, stock market investors have been eating at the bit for the past fortnight, fueled yet again by Fed ‘pivot’ talk.

It could all be wishful thinking, but it is not the first time this year. There is no official pushback because Fed speakers are not available during the traditional blackout period prior to next week’s meeting.

One metric that investors may have used to encourage them to place another bet on the light at the end 2022’s tunnel is an inversion, or a part of the U.S. Treasury yield-curve the Fed claims to prefer when assessing the possibility of a recession.

Graphic: Fed alert https://graphics.reuters.com/GLOBAL-RATES/klpygeqkdpg/Screenshot%202022-10-27%20at%2016.53.32.png

Graphic: Central banks ramp up fight against inflation https://graphics.reuters.com/EUROZONE-MARKETS/zdvxdyxbwvx/chart.png

INVERSION DIVERSION

Investors often look at the gap between 2- and 10-year yields to predict future activity. Inversion of longer rates below shorter rates has frequently preceded past economic contractions of about 18 months.

The 2-10 yield curve was inverted in April for almost three years, just after the Fed’s first hike. This caused recession anxiety. Although the curve sank quickly for a few more months, it returned to a deeper and longer-lasting inversion from July.

The Fed’s inability to care, or at least not to agree with the market, was the biggest market concern. Instead, it used other measures to show that it had plenty to tighten and remain focused on inflation.

Fed economists argued passionately that the 2-10 yield yield curve was not reliable. They insisted that a’soft land’ was still possible if shorter-term yield spreads that remained positively accurate were used.

This week, however, things have changed.

A measure of the yield curve that is longer than 3 months or 10 years, used by the New York Fed to calculate recession probabilities, fell into negative territory for first time since the pandemic.

In March’s blog ‘(Don’t Fear) the Yield Curve’, Fed Board economists Eric Engstrom & Steven Sharpe discredited the obsession with a 2–10 year inversion. They calculated near forward rate spreads of 3-month borrowing rates and implied 3-months interest rates 18 months later. This was much more accurate than previous estimates.

Although the spreads were positive back then, they have turned negative in the near term and the implied 3-month rate for 18-months fell below the current 3-month rates for more than a decade.

Investors may feel that confirmation of recession is imminent is a comforting thought, but it could also allow Fed to assume that it is gaining enough momentum to stop inflation and take the brakes a little.

Morgan Stanley (NYSE:) Economists warned their clients not to confuse a slowing down of Fed hikes with a lower desire to raise policy rates. They expect the Fed to “indicate soon that it could be appropriate to reduce the pace of hikes” but they see only a 50-bp increase in December.

Graphic: Rates up, inflation sideways https://graphics.reuters.com/USA-FED/INFLATION/gkvlgnaywpb/chart.png

Graphic: US GDP breakdown https://graphics.reuters.com/USA-STOCKS/mopakmqxopa/gdp.png

Graphic: US economic surprises still positive https://fingfx.thomsonreuters.com/gfx/mkt/egvbynjykpq/One.PNG

These opinions are the opinions of the author, a Stocksak columnist.

(by Mike Dolan. Twitter: @reutersMikeD. Reporting by Nell Mackenzie, Editing by Kirsten Doovan

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