A Powell-Backed Yield Curve Gives Fed Cover to Go Max Hawkish
Comment of the Day

March 25 2022

Commentary by Eoin Treacy

A Powell-Backed Yield Curve Gives Fed Cover to Go Max Hawkish

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

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.

Campbell Harvey was one of the first to historically show the link, with his work on the three-month, 10-year spread -- which has inverted before each of the past eight U.S. recessions. These days, the professor at Duke University’s Fuqua School of Business is concerned about growing threats to the U.S. recovery, even though his beloved spread is not yet flashing “code red.”

High inflation and “geopolitical risk -- which we haven’t even felt the economic outcome of yet, besides at the gas pump -- is all acting like a tax,” Harvey said. “It all indicates slower economic growth.”

Eoin Treacy's view

Cherry picking the one part of the yield curve that is not at danger of inverting seems to be intellectually dishonest to this observer. Instead, we should be attempting to answer the question why 3-month yields are so depressed.

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