Fed to the rescue. In scheduled public comments, Fed Chair Powell vowed tough action on inflation, which he said jeopardizes an otherwise strong economic recovery. Powell reiterated that interest rate hikes would continue until inflation is under control. If necessary, the increases could be even higher than its recent quarter-percentage-point hike. Powell also addressed the Russian invasion of Ukraine, saying it is adding to supply chain and inflation pressures. Under normal circumstances, the Fed would generally look through those types of events and not alter policy, he said, but with the outcome unclear, policymakers must stay on the alert.

Markets are now expecting the Fed Funds rate to reach 2.8% in 2023 – it’s 0.33% now – beyond the so-called neutral rate of about 2.4% that neither speeds up nor slows down economic activity. Market data are showing slightly better than 50/50 odds that the Fed will hike by 0.50% at its next meeting on May 4^th. The Treasury yield curve flattened further on Powell’s comments, with the yield difference between the 2-year Treasury note and its 10-year counterpart narrowing to just 0.20%, coming ever closer to inversion.

Our take: While the style of Chair Powell’s statements last week was slightly more aggressive than at his post-meeting press conference two weeks ago, the substance was largely the same. The fact that Treasury yields spiked higher anyway tells us that financial markets are still coming to grips with the new policy reality. We’re left with a Treasury yield curve that’s a cliff-face out to three years or so, and then close to pancake-flat thereafter.

The rise in short-term Treasury yields has been breathtaking: two-year yields are up a whopping 79 basis points this month. That’s the biggest monthly rise since April of 2004, and if we tack on another couple of basis points then you’ll have to go all the way back to 1989 to find a yield move of greater magnitude.

Which brings us to what such a move in short-term yields has done: flattened Treasury yield curves close to inversion, spurring much of the financial news media to shout warnings of looming recession from the rooftops. Take a step back; a flattening Treasury yield curve isn’t flagging the panic signals that many would have you believe. Inflation and a shifting rates regime provide ample reasons for investors to be fearful, no doubt. War is another. But the last 13 years of extraordinarily easy monetary policy means that most investors have forgotten how to interpret curve inversion signals and there’s a lot of misinformation at play.

Looking back the past 30 years or so, when an inverted yield curve  did lead to a recession, it took an average of 18 months from the initial inversion for recession to actually set in. For example, the yield spread between the 2-year versus 10-year went negative in December 2005, two full years before the ensuing economic downturn. The time to run for the hills is when the yield curve re-steepens after its initial inversion. That’s a time when the Fed would likely be cutting rates, as the economy slows. Markets are expecting a rate cut in 2024, which isn’t unreasonable. Until then, resist the inversion hype.

Another erroneous belief is that the Fed hiking 0.50% is extremely rare. Sure, we’ve not had a hike of that magnitude for more than 20 years, but we’ve also not had a properly hawkish Fed over that period. Hikes of that magnitude used to be common enough in all prior hiking cycles, specifically during the 1991-2000 Greenspan-era Fed, when the Fed hiked 25/25/25, only to see the yield curve fail to really move at all. The Fed responded with hikes of 50/0/50/0/75/0/50.

We doubt that hiking profile is likely this time around and instead expect a series of consecutive hikes of varying intensity, wrapped with a bow of Fed balance sheet reduction. In the meantime, the Treasury yield curve still has a ways to go before it inverts  – 20bps or so when looking at the 2-year versus 10-year Treasury yields, 30 basis points for the 2-year versus 30-year, and most importantly 27 basis points for the 2-year versus 5-year, which we feel provides the most accurate recession signal. If anything, this yield curve measure – which has shown steepening rather than flattening – is signaling optimism in a largely pessimistic world:

Bottom line? For those of you looking for some type of rate hike U-turn from the Fed upon any inversion of the Treasury yield curve, you can forget it.   With a renewed openness to 0.50% rate hikes combined with a looming reduction of its balance sheet, we’re betting the Fed is prepared to look through curve inversions as it focuses on its core goal: bringing down inflation.