The Fed is not at the mercy of the yield curve


But looking at the broader picture of the predictive power of yield curves, it’s really only when they invert significantly and for several quarters that the recession warning holds. A brief flirtation can often be a false signal. And while economists polled by Bloomberg see an increased risk that the US economy will suffer two quarters of contraction in the coming year, the chance of a recession is still only 20%.

Whisper who dares, but this time is also different. With a Fed balance sheet of $9 trillion after more than a decade of quantitative easing, the central bank has more tools than just raising the fed funds rate. By holding such a share of the bond market, it can steer longer-term returns by choosing which maturities to buy and sell as it rolls out its bond-buying program.

Powell told us that his preferred way of looking at the Treasury yield curve is not to focus on the two-to-10-year spread, which is rapidly approaching zero. Instead, he favors the shorter end of the money market curve, where there is still a 180 basis point differential to longer yields. The size of this gap suggests that a recession may not be imminent and explains why Powell pointed to the tightness of the labor market as explaining why he prioritizes the need to rein in inflation over risks to the economy. the growth.

The combination of active balance sheet reduction with rate hikes increases the danger of a bond market upheaval, as happened early in Powell’s tenure. But the Fed needs to set the stage for the reduction in stimulus.

Markets are clearly listening to the Fed’s interest rate forecast and have reversed the decline in yields triggered by the flight to quality following Russia’s invasion of Ukraine. Including this month’s quarter-point increase, there are now 200 basis points of rate hikes for this year, which would be the biggest 12-month tightening in monetary conditions since the 250 basis point upward move in 1994. Chances Are Traders will also be paying attention to what the Fed has to say about quantitative tightening.

The Fed finally stopped adding to its QE stack this month. It could start trimming its balance sheet as soon as its next meeting in May, though combining that with the 50 basis point rate hike that Powell has threatened to roll out might be too aggressive. Nevertheless, even though the “flow” of bond purchases may have stopped, the “stock” effect of such a large balance sheet will stimulate the economy for many years to come.

The so-called “taper tantrum” of 2013 taught the Fed a salutary lesson about the dangers of surprising bondholders by withdrawing support too quickly. But the authorities will not and should not hesitate to influence longer-term returns if and when necessary. This doesn’t need to precipitate a market rout; simply reminding traders and investors that the central bank has bonds available for sale would do a lot of work in restoring some slope to the overall shape of the yield curve.

This would be the very definition of the “agile” approach that Powell has repeatedly emphasized and intends to pursue. In the wake of the global financial crisis, the Fed Chairman’s predecessors created a range of unconventional monetary tools; he can now use them to aggregate bond yields as he sees fit.

More from Bloomberg Opinion:

• The Fed is pushed into the camp of developing economies: Mohamed El-Erian

• Fed predictability and laziness have their costs: Richard Cookson

• Now that the markets are convinced by Powell, he means it: John Authers

This column does not necessarily reflect the opinion of the Editorial Board or of Bloomberg LP and its owners.

Marcus Ashworth is a Bloomberg Opinion columnist covering European markets. He spent three decades in banking, most recently as Chief Market Strategist at Haitong Securities in London.


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