Jerome Powell had a simple response this week for doomsayers who point to scary Treasury-market moves as evidence that the Federal Reserve will tip the economy into recession through its tightening campaign: You’re looking at it all wrong.
Instead of fixating on ominous bond shifts—like the five-year rate trading above its 10-year counterpart and a flatter U.S. curve, more generally—traders on Wall Street should take their cues from another corner of the debt world altogether: the short-term yield curve.
On Monday, Powell cited the steepening gap between the forward-implied rate on three-month Treasury bills versus the current three-month level as a tell-tale sign that the bond market has actually given an economic all-clear.
Powell’s message at the National Association for Business Economic was unmistakable: the Fed has plenty of room to aggressively jack up rates to fight inflation without choking growth.
Treasuries are taking another beating Friday with Citigroup Inc. ramping up projections for rate hikes including four straight half-point moves, while the gap between five- and 30-year Treasuries dipped into single digits to the lowest levels since 2006.
As such, warnings of a recession-inducing policy mistake are growing. This week, Goldman Sachs Group Inc. joined those predicting a “modest inversion” in the two- to 10-year spread by the end this year. Inversion, where short-term yields exceed longer-term ones, is a time-honored and widely followed indicator of oncoming growth trouble.
“It’s becoming more and more clear that the Fed is willing to risk growth to fight inflation,” said Peter Yi, director of short-duration fixed income and head of credit research at Northern Trust Asset Management. “Powell has been suggesting that every meeting is live and a 50 basis point hike at every meeting is a possibility, which is going to create pressure for the curve to invert.”
The near-term forward spread measures the difference between bets on where the three-month rate will be in 18 months’ time and that same rate today. That curve, along with the more traditional three-month, 10-year spread, has steepened to multi-year highs, spurred by expectations that a hawkish Fed may frontload interest-rate increases, taking the federal funds rate to about 2.8% at the end of 2023.
A 2018 Fed research paper highlighted that the shorter-term yield curve eliminates complicating factors like the so-called term premium, and thus gives a cleaner read on market expectations for future monetary policy. In effect, the gauge would only invert when a large cohort of investors expected rate cuts on the basis of slowing growth. Previous Fed research has found it has a better predictive power than other parts of the curve—a conclusion the chair endorsed Monday.
History has shown that when the force of a Fed tightening cycle causes a yield-curve inversion, it foreshadows a pending recession as consumer spending and business activity increasingly buckles under the weight of policy tightening.