A Deeply Inverted Yield Curve Means Credit Is Set to Dry Up Next
Comment of the Day

July 12 2022

Commentary by Eoin Treacy

A Deeply Inverted Yield Curve Means Credit Is Set to Dry Up Next

This article from Bloomberg may be of interest to subscribers. Here is a section:

The other constraint is the so-called ‘spot real rate’, which measures the Fed’s target rate minus current headline inflation. The premise is that the Fed cannot tighten financial conditions sufficiently to wring out inflation if it ends rate hikes with the spot real rate still negative.

Putting this together, if the Fed gets to, say, a 4.5% target rate with inflation in 2Q 2023 at the same level, maybe it can call it a day. That’s a very high inflation level but also a restrictive level of policy which will mean significant economic pain. If, for example, the US economy lapses into recession and inflation falls to 4%, the Fed might feel confident that inflation was headed down to its 2% target even if the fed funds rate is only 3.0% when this occurs.

The scenarios above are more akin to the early 1970s when the Federal Reserve allowed real yields to remain negative in the face of double digit inflation. It’s not the crushing blows that Paul Volcker administered to the US economy.

Even so, inflation is so high that there are almost no scenarios where the fed funds rate doesn’t get to at least 3 or 3.5%. More likely we go higher than that.

That’s when banks will likely face problems with defaults and net interest margins.

Eoin Treacy's view

The 10-2-year yield curve spread is currently at negative 9 basis points. That’s the most inverted the spread has been since 2007. Jay Powell dismissed this indicator as useful and prefers to look at the 10-year – 3-month spread. That measure has contracted by 40 basis points since Friday. In early May it was at 230 basis points. Today it is at 80.

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