The fate of the flattening US yield curve now rests squarely in the words of Federal Reserve officials.
Bond traders have already reached their verdict. The yield spread between 5- and 30-year Treasuries narrowed last week to as little as 26.2 basis points, the lowest since August 2007. The prospect of an inverted curve, which has presaged past recessions, is as strong as ever. And it’s not just Wall Street scrutinising the development — St. Louis Fed President James Bullard said it’s “crunch time” for inversion, predicting it could happen later this year or in 2019 if the Fed keeps up its pace of rate hikes.
Several more central bankers will have a chance to opine on the phenomenon this week, including incoming New York Fed President John Williams, while the nominee for Fed vice chairman, Richard Clarida, will face Congress. What they signal may prove pivotal in a period otherwise lacking in debt auctions and top-tier data.
Any hints that the looming inversion has them contemplating a slower pace of rate increases could spur another bout of bull steepening, like after policy makers’ May meeting. If they ignore the curve, there’s little to stop the grind flatter.
“The Fed is supposed to adjust rates when the economy is doing well and inflation may pick up, but at some point they would have to stop,” Krishna Memani, chief investment officer at OppenheimerFunds Inc., said in a Bloomberg TV interview. But if they let the curve invert, “all they will do is take the US economy down the drain.”
It’s hard to overstate the flattening move in the US yield curve. Select just about any two maturities, and the gap between them has shriveled over the past year.
At one point last week, investors picked up a mere 2 basis points for owning 10-year Treasuries instead of seven-year debt. Strategists at BMO Capital Markets said in a report Friday that if that portion of the curve inverts, others are likely to follow, possibly within 25 to 35 trading days.
It’s far from certain the Fed will slow down as the curve flattens, given the new make-up of the voting body. Kansas City Fed President Esther George, possibly the most hawkish US central banker, is likely to vote on the Federal Open Market Committee for the first time since 2016 as part of a reshuffle with the retirement of New York Fed President William Dudley.
Nor is it clear they should take their feet off the gas. Though rooted in Fed policy and low inflation, the flattening has been sustained by Treasury supply and demand trends. The government is concentrating the auction-size increases required to finance wider deficits in short maturities, while pension funds’ appetite for long maturities is expanding, TD strategists said.
Traders, for their part, are betting on persistent rate hikes. In fact, fed fund futures are pricing in between two and three additional increases this year, which is above the central bank’s forecast of two more in 2018.
The economic data of late have supported the market’s view. The Fed’s preferred inflation gauge reached 2 percent for the first time in 13 months, while the unemployment rate is below 4 percent. The Fed doesn’t have a mandate to monitor the shape of the yield curve, of course. But officials in the days ahead may still have to answer for its relentless flattening.