Resist the Inversion Hype
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What You Missed: Both short- and long-term interest rates shot higher, and equities struggled to advance on the week, as markets continued to absorb a growing consensus that the Fed is firmly on a path of successive rate hikes. The yield on the US 10-year note rose to 2.48%, its highest level since May 2019, following Fed Chair Jay Powell’s remarks on inflation. Short-term rates, like the 2-year Treasury yield and SOFR both posted sizable rises on the week. Elsewhere, the price of a barrel of West Texas Intermediate crude oil rose to $113.47 from $104.69 as the US Dollar traded flat and Gold strengthened. Treasury yield volatility, a key driver of the cost of rate caps, rose sharply to a three-week high.
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 4th. 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.
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What to Watch This Week: Comments by Fed officials since its policy meeting two weeks ago have confirmed one thing: The Fed would probably have hiked rates by 0.50% had Russia not invaded Ukraine.
While we’re all living with inflation effects that the war immediately exacerbated – like gasoline prices – its dampening effect on growth or the jobs market has yet to show up. Data on the docket this week will help clarify the situation (personal consumption, Thurs.; vehicle sales, Fri.; job openings and labor turnover survey, Tues.).
As Fed Chair Powell recently highlighted, the Fed is no longer comfortable looking through what textbooks typically would consider “transitory” inflation. Thus, we suspect this week’s release of solid jobs (nonfarm payrolls, Fri.; ADP, Wed.) and inflation data (PCE deflator, Thurs.; Case-Shiller Index, Tues.) will cement the resolve of Fed committee members for the need for a 0.50% hike at the Fed’s May meeting.
Elsewhere, we’ll get an updated peek into the state of supply chains (ISM manufacturing, Fri.), with worsening expected due to the resurgence of Covid in China. Adding another layer to the supply-chain pain is a likely delay in negotiations on a new union contract for West Coast port workers – the deadline is July.
Big Picture: The deepening bond-market rout has driven Treasury yields past a threshold that could signal the end of a decades-long declining trend.
10-year Treasury yield recently rose to just shy of 2.5%, the highest since May 2019, and up more than a full percentage point since early December, as the Fed prepares for an aggressive cycle of interest-rate hikes. This is a far faster and steeper rise than during previous monetary-policy tightening cycles, and it has already pushed the 10-year yield over a technical trend line that has effectively acted as a ceiling since the late 1980s:
Current Select Interest Rates:
Rate Cap & Swap Pricing:
LIBOR Forward Curves:
1-month Term SOFR Curve:
10-year Treasury Yield:
Source: Bloomberg Professional