The Strawman of the Yield Curve and What Will Really Move Markets in the Week Ahead


The US/yield curve inverted last week, triggering a flurry of materiality comments. Simply put, market participants don’t believe the is necessarily a harbinger of a recession, with the possible exception of a few headline writers. Some observers installed a simple straw man and proceeded to slaughter him. They don’t really say the Fed will achieve the proverbial soft landing by pushing price pressures down without rising unemployment, as Fed officials’ median forecasts showed a few weeks ago.

Consider Bill Dudley’s latest critique of the Federal Reserve, released hours before the 2-10 curve reversal in the middle of last week. The headline says it all: “The Fed Made a US Recession Inevitable,” and it doesn’t once quote the yield curve. Instead, it focuses on the impact of the needed tightening on unemployment. It is based on the “Sahm rule” according to which if the three-month average of unemployment increases by more than 0.5%, a recession is inevitable.

The reason why our outlook has darkened does not directly have to do with the yield curve either. We have seen monetary and fiscal policy tighten pro-cyclically as the economy was pumped up by massive stimulus and pandemic easing was already slowing. Say what you want about Powell, but the market is in a historically aggressive tightening for the rest of the year. The market is not waiting for the Fed to move. Rates jumped a multiple of the Fed’s 25 basis point hike. From the March 1 low to the April 1 high, the two-year note rose 120 basis points. At its highest on March 29, the 2-year rate rose by just over 100bp this month.

Many critics underestimate the power of the central bank’s communication channel, which also speaks to the credibility of the Fed. Some critics say the Fed’s credibility has been undermined by its long lag on the curve, but struggle to provide convincing evidence. Also, it seems that the role of the market as a discounting mechanism is not sufficiently recognized. Powell & Co have signaled their intention to , and the market believes them. This is why a tightening of 216 basis points has been priced into the Fed funds futures market. Of the six remaining FOMC meetings this year, Fed funds futures strip pricing is consistent with two 50bp hikes and leaning (nearly 70% chance) toward one-third.

At the same time, fiscal policy is tightening considerably, but it does not seem to receive the same attention as monetary policy. Bloomberg’s median survey forecast is for the budget deficit to more than halve, from 10.8% to 5.1%. To say that this is the largest percentage point decline in the fiscal deficit may not reflect the magnitude of the ongoing fiscal contraction. Consider that it took four years (2010-2013) to reduce the deficit was as much after the Great Financial Crisis. The smaller deficit partly reflects lower spending. Lower public spending translates into lower household incomes. Income helps stimulate consumption, which contributes something on the order of 70% to the US economy.

Besides the significant tightening of monetary and fiscal policy, another major obstacle is rising food and energy prices. The reason they are excluded from the common but not universal measure of is not that they are volatile, as some claim. They are excluded because the variation of their prices is determined by supply and not by demand. And, over time, converges to the base rate, not the other way around. Compression of the cost of living will probably have a negative impact on consumption. The last three recessions were preceded by a doubling in the price of oil. Consider that the 20-day moving average was near $47.50 at the end of 2020 and is now around $107.60.

Two tailwinds to growth in recent quarters cannot be counted in the future. First, the inventory cycle is mature after accounting for the lion’s share of growth in the last three months of last year. Businesses are still hoarding inventory, but what matters is change within change, and that is expected to slow down in the future. Moreover, the surge in savings spurred by the decline in consumption and transfer payments have been reduced, especially for low- and middle-income households.

In a relatively lackluster week of US economic data, the minutes of the recent FOMC meeting may be the most anticipated (April 6). Chairman Powell said at his press conference that this would provide more information on his thinking on the upcoming balance sheet reduction. There are two issues, timing and pacing. Word clues from Fed officials suggest the unraveling may begin soon after the May 4 FOMC meeting. Like the 2017-2019 experience, there may be a flying start.

The balance sheet shrinks when the Federal Reserve does not reinvest the full principle amount of its maturing assets. In 2017-19, the Federal Reserve allowed a maximum of $30 billion in Treasury bills and $20 billion in mortgage-backed securities per month not to be reinvested. Consensus seems to favor a faster pace, and some suspect it may be a combined total of $100 billion. This time, the Fed’s balance sheet includes about $325 billion in Treasuries; the last time, none. It might add another wrinkle, but we suspect the bills sector won’t be included in the caps. Maturity of Treasuries will extinguish reserves, and by allowing Treasuries to roll over as they mature, use of the Fed’s reverse repo facility will likely decline.

The next round of major central bank meetings kicks off on (early April 6 in Sydney). Nobody expects him to do anything. The authorities have only recently begun to allow a rate hike this year. The economy is strong, with first-quarter growth expected to be around 1% quarter-on-quarter. February’s 4% is what appears to be a record low. Wage growth was modest (2.3% YoY in Q4-21). Some see the June minimum wage setting as a potential inflection point.

Consumer inflation expectations (Melbourne Institute survey) hit 4.9% last month, the highest since 2012. Economists (median in the Bloomberg survey) see Australia hit 4.3% this year after 2.9% in 2021. Like other countries, Australia’s fuel tax cut (50%) will contribute to reducing the measured pressures on prices. On the other hand, the pre-election budget will provide more fiscal stimulus than expected. Australia is also experiencing a positive terms of trade shock. The price of its exports is jumping, while the prices of imports are less so. The new free trade pact with India will not be implemented within a time frame which would have an impact on monetary policy. Yet it offers an important counterweight to deteriorating relations with China.

Spot rate futures are almost 25 basis points fully priced for the central bank’s June meeting. If this is really going to happen, it’s reasonable to expect officials to start laying the groundwork. At first, Governor Lowe would acknowledge the strength of the economy and the easing of COVID. It seems clear that the monetary accommodation provided during the pandemic is no longer necessary. The RBA raised the target cash rate from 0.75% in February 2020 to 0.10% by the end of the year. It seems prudent to set a course to bring it back to pre-COVID levels. Policy would still be very accommodative, and the cash rate would still be well below inflation and inflation expectations. The swap market has around 110 basis points of discounted tightening over the next six months. It seems too aggressive.

Two other high frequency data points are notable in the coming week. The first is the month of February of Japan. Without fail, the February balance always improves from January. This month of January was in deficit (~-JPY1.19 trillion or ~$9.7 billion), and February should return to surplus (~JPY1.45 trillion). Japan recorded an average current account surplus of almost 1.3 trillion yen. The average in 2019 was 1.6 trillion yen. However, many observers will be surprised that Japan’s current account surplus is not trade-driven. On a balance of payments accounting, Japan recorded a monthly average of 146 million yen last year and 12.5 million yen in 2019.

Perhaps the most important impact of Japan’s depreciation is not to boost exports, but to increase the value of the overseas earnings of its Japanese companies. This comes in the form of dividends and coupon payments for portfolio investors. The yen value of profits, royalties, license fees, etc., earned overseas will increase for businesses.

The second high-frequency data point next week is from Canada. Recall that Canada reported an inflated number of 336,600 jobs filled in February, of which 121,500 were full-time positions. Given that the Canadian economy is about 1/11 the size of the United States, it would be as if the United States had reported a 3.7 million increase in nonfarm payrolls. After the revisions announced before the weekend, the United States rose by 750,000 in February. The fell to 5.5% from 6.5%. This is the lowest rate since May 2019. It is almost as high as before the pandemic (65.4% against 65.5%).

It is unreasonable to expect another strong report. The Bloomberg survey’s median forecast predicts an additional 79,000 jobs will have been filled with more than half (nearly 42,000) of full-time positions. This is the last important data before the April 13 meeting of the Bank of Canada. The swap market has about a 2/3 chance to move 50 bps next and 170 bps over the next six months (five meetings).


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