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With Yield Curve Inversion; Pressure on Fed to Cut 50 Bps

Vito J. Racanelli

Federal Reserve Board policymakers were unusually quiet last week during the dog days of summer. I’m assuming some were vacationing. (There was an unconfirmed report that chairman Jerome Powell put out a gag order.) But if Fed folks thought it’d be an easy summer week, they were wrong.

Indeed, it just might turn out to have been the most important week of the year for the Fed and, consequently, for markets, too. If you don’t know that the yield curve inverted briefly last week, then you were perhaps too busy navel gazing with your headphones securely glued to your ears. On Tuesday the yield spread between the 2-year U.S. Treasury note and the 10-year went negative briefly, to the tune of a few basis points, and all hell broke loose. It was as if the salmon were running, as the bears showed up en masse and the stock market dropped like a felled heavyweight, 3% in one day. (For more on that see page 1.)

Of course, a curve inversion—where the yield on the shorter-term note is higher than the longer term—is taken as an omen of a recession. However, as this publication has pointed out numerous times, which bonds invert matters. The 3 mos.-10 year yield curve inverted a while back and the 2-yr-10-yr inverted last week briefly, but the latter are no longer inverted. (See page 3.)

I don’t ignore the 2-yr-10-yr, but the 10-yr-30-yr curve counts as the most reliable signal. It remains solidly in the black at about 45 basis points, even as both bond yields have dropped sharply. Another point of contention by the bears is that the 30-year yield, currently around 2% is the lowest it has been in many decades. Cue the panic.

Never one to be left out of a shouting match, President Donald Trump unloaded a withering tweet against the Fed, calling it and the chairman “clueless,” and claiming “the Fed is holding us back.” So, with all these matters hitting the Fed, I’d say the rate cut pressure on the U.S. central bank just went to Def Con 2. If any of the Fed policymakers are on vacation, I’m thinking they aren’t having a very relaxing time.

What’s gotten my attention more than anything else is the CME Fed futures market. I’ve pointed out before how accurate that market is. During last week Fed futures probability of a 50 bp cut in September rose to 42% at one point from 10% earlier in the week. It’s currently back down to about 20%. I believe a 25 bp reduction is a foregone conclusion, even though Powell is on the record as suggesting that even the latter isn’t in the cards.

We’ll see. The Fed might be forced to do 50 bps. That’d be ironic. The Fed has continually shouted about its independence, but it might be forced to do Trump’s bidding against its will.

While inversions can presage recessions, the why of this inversion is peculiar. Fact is, that negative rates in other developed country bond markets, makes even the low rates of US Treasuries look positively scrumptious. Some of this is carry trade, pushing long term yields down, while the Fed jacks up rates at the short end. Presto, inversion.

The 10-yr note yield ended Friday around 1.55% versus 1.74% the previous week.

Upcoming: 9/17-18 - FOMC meeting. That’ll be fun.

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Vito J. Racanelli
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