The Daily Update - When to Worry About an Inverted Curve

Over the past week the term spread between 2-year and 10-year US Treasuries has averaged 25bps – equivalent to just one more Fed rate hike. Also earlier this week the 3-month Treasury bill yield touched 2% for the first time since 2008; this means that even short-term bonds now yield more than US stocks for the first time in a decade – becoming a viable alternative for those apprehensive about both stocks and bonds. Also earlier this week Fed Chair Jay Powell left markets guessing with just a couple of words of ad-libbing during his testimony to Congress, stating, “With a strong job market, inflation close to our objective, and the risks to the outlook roughly balanced, the FOMC believes that (for now) the best way forward is to keep gradually raising the federal funds rate.”

“For now” left many suspecting that the Fed want markets to know they are watching the flattening of the yield curve yet aren’t perturbed from “gradually raising the federal funds rate” even if it inverts the US Treasuries active curve. It seems markets are increasingly accepting of this eventuality and less fearful now than they were a few months ago; perhaps due to just how long a leading indicator the 2-10 term spread is. It is not a portent of immediate doom but rather a warning light for the coming 12-months or so; given that any potential inversion will likely be towards or beyond the end of 2018, markets aren’t expected to firesale stocks any time soon when the expectation is for another 1-2 years to potentially reallocate assets.

For now the term spread narrowing is normal for a tightening cycle as short-term rates react faster to monetary policy whereas we have seem seemingly limitless demand for 30-year Treasuries even in the face of growing supply reflecting continuing confidence in central banks and concern for central government and trade disputes. The new precedent to watch out for, however, isn’t raising rates causing an inverted curve but the Fed continuing to raise rates after an inversion of the yield curve. 20 years ago, when the 2-10 spread inverted in 1998, the Fed responded with a rate cut. Short of a financial crisis, no one is expecting the Fed to cut rates any time soon – but if they continue to raise rates even as short-term yields exceed long one should certainly be on the lookout for any other signals of a recession and any vulnerabilities in equities and weaker credits.

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