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  • Writer's pictureStephen H Akin

Yield Inversion

Updated: Aug 8, 2022

An inverted yield curve is a favorite recession indicator of the Federal Reserve Board. When inverted it suggests that the near-term is riskier than the long term.

Bond markets are flashing a warning signal about the growth prospects for the US economy, just as central bankers prepare to tackle soaring inflation with higher interest rates.

The gap between long-term and short-term government borrowing rates in big developed economies has narrowed drastically since the autumn. In the US, a so-called “yield-curve inversion” occurred last week for the first time since 2019 - an event that in the past has been the harbinger of economic downturns.

Indeed the financial press has been sounding the alert:

  • Bloomberg - "Widely Watched Yield Curve at Most Inverted in Decades After Fed Rate Hike"

  • CNBC - "US Bond Yield Curve Inversion Between 10 Year and 2 Year Rates Reaches Biggest Point Since 2000"

  • Financial Times - "An Inverted Yield Curve and Why Investors Are Watching Closely"

Reuters did a great job wrapping up what Fed members said recently, Check it Out!

Fed officials stay resolute on need to make policy more restrictive

Lindsay Dunsmuir and Dan Burns Tue, 2 August 2022, 12:02 pm·4-min read

By Lindsay Dunsmuir and Dan Burns (Reuters) -A trio of Federal Reserve officials from across the policy spectrum signaled on Tuesday that they and their colleagues remain resolute and "completely united" on getting U.S. interest rates up to a level that will more significantly curb economic activity and put a dent in the highest inflation since the 1980s.

Moreover, one of them - San Francisco Fed President Mary Daly - said she was "puzzled" by bond market prices that reflect investor expectations for the central bank to shift to rate cuts in the first half of next year. On the contrary, she said her expectation is the Fed will keep raising rates for now and then hold them there "for a while," remarks that triggered a wave of selling in rate-futures markets.

In a separate appearance, Cleveland Fed President Loretta Mester struck a similarly hawkish tone, noting that inflation has yet to peak and she needs to see several months of very compelling evidence that inflation is on a sustainable path down to the central bank's 2% goal before policymakers can ease off.

Their new uniform remarks reverberated in bond and interest rate futures markets that had emerged from last week's meeting positioned for the central bank to dial back the pace of rate hikes. Expectations the Fed would reverse course and start cutting rates in the first half of 2023 diminished significantly as reflected in fed fund futures pricing, while the probability of another 75 basis point increase next month moved notably higher.

The yield on the 2-year Treasury note - the government bond maturity most sensitive to Fed policy expectations - rose by 20 basis points, the most in nearly two months. Fed Chair Jerome Powell said last week the central bank may consider another "unusually large" rate hike at its Sept. 20-21 policy meeting, with officials guided in their decision making by more than a dozen critical data points covering inflation, employment, consumer spending and economic growth between now and then.

Chicago Fed President Charles Evans told reporters on Tuesday that if inflation does not abate before then, he would back such a move.

"If you really thought things weren't improving ... 50 (basis points) is a reasonable assessment but 75 could also be okay. I doubt that more would be called for," Evans said during a question-and-answer session at the regional bank's headquarters in Chicago, effectively dismissing the prospect of raising rates by a full percentage point next month. The central bank raised its benchmark overnight lending rate by another three-quarters of a percentage point last week to a target range between 2.25% and 2.50%. It has hiked that rate by 225 basis points since March as officials have been increasingly aggressive to try and quash stubbornly high inflation even as recession fears gather pace.

'NOWHERE NEAR' San Francisco Fed's Daly said the central bank's work of bringing down inflation is "nowhere near" almost done and there is still "a long way to go" to lower inflation from four-decade highs.

"That would not be my modal outlook," she said in an interview streamed on LinkedIn and hosted by a CNBC anchor when asked about investor expectations of rate cuts. "My modal outlook, or the outlook I think is most likely, is really that we raise interest rates and then we hold them there for a while at whatever level we think is appropriate."

Mester struck a similarly bullish note. "We have more work to do because we have not seen that turn in inflation," Mester said in an interview with the Washington Post. "It's got to be a sustained several months of evidence that inflation has first peaked — we haven't even seen that yet — and that it's moving down."

"You wouldn't want to conclude too quickly inflation is on a downward path because of how high it is...I want to see it broadly across many inflation measures, not just one, not just two," she added.

Evans too noted that he thinks the Fed's policy rate will have to rise to between 3.75% and 4.00% by the end of next year, but cautioned against too quick a path to get there should it have to retrench unexpectedly on the back of a changing landscape.

The economy continues to flash conflicting signals with the tightest labor market in decades strongly pushing up labor costs in the second quarter but economic growth contracting for a second straight quarter. The Fed is trying to dampen demand across the economy to help bring down price pressures without causing a spike in unemployment.

U.S. job openings fell by the most in just over two years in June as demand for workers eased in the retail and wholesale trade industries, the Labor Department reported on Tuesday, although other details suggested the labor market remained extremely tight.

Evans said that he had downgraded his expectations for economic growth this year and now sees it coming in at 1% or lower, but added that he still sees a path for the Fed to bring down inflation while keeping the unemployment rate below 4.5%.


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