Investors will likely weigh every word from Federal Reserve Chairman Jerome Powell this week to see if he bows to pressure to pause the central bank’s expected interest-rate increases.
Powell’s speech, on Wednesday, along with that of his No. 2, Richard Clarida, on Tuesday, will return the spotlight to the flattening yield curve, the bond market’s trusty indicator of upcoming recessions. Those remarks will hit as some critics, including President Donald Trump, have called for the Fed to slow its pace of rate hikes amid stuttering stocks and slowing global growth.
How the curve swings and sways could indicate how markets anticipate the central bank response to the tug of war between a robust U.S. economy and investor pessimism over its long-term prospects.
“Powell’s appearance on Wednesday will be a test of his resolve to continue normalizing [interest rates] in the face of the reoccurring weakness in the equity market,” wrote Ward McCarthy, chief financial economist for Jefferies.
See: Trump wants Fed to cut interest rates after stock-market wipeout, but history not on his side
Equities have struggled as concerns over tighter monetary policy offset strong earnings and buybacks. Through Friday, the S&P 500
SPX, +1.40%
was down 10.2% and the Dow Jones Industrial Average
DJIA, +1.29%
was off 9.5% from its record closing highs, FactSet data shows.
The bond market has also shown unease over the Fed’s tightening trajectory.
Analysts say the yield curve, depicted by the gap between short-dated and long-dated yields, has renewed its flattening amid the bond market’s fears that the Fed’s rate increases will take a toll on growth. In other words, market participants worry the central bank will make a misstep, lifting rates when tariffs and a global economic slowdown have shown signs of crimping corporations’ bottom lines and business spending.
Read: Stock-market investors are sending Fed’s Jerome Powell a crystal-clear message
John Herrmann, rates strategist for MUFG Securities, said the central bank should pause its rate-hike cycle in the first half of next year to avoid an economic downturn in 2020.
After briefly widening in October, several measures of the yield curve have narrowed to pre-recession levels. In the market’s mind, that raises the specter of the feared curve inversion, which when triggered, has historically been followed by an economic slump.
The gap between the 2-year note yield
TMUBMUSD02Y, +0.89%
and the 10-year note yield
TMUBMUSD10Y, +0.93%
, a popular way to gauge the curve’s slope, stood at 24 basis points on Friday, near its decade-long low of 20 basis points in August.
And another measure, the spread between the 10-year note and the 3-month bill
TMUBMUSD03M, -0.11%
fell to 65 basis points at the end of last week, its narrowest since 2008. A model throwing out recession probabilities based on the width of this gap estimated the chance of an economic downturn by the end of October 2019 at around 14%, its highest levels since the 2007-09 recession, according to the New York Fed.
Powell and Clarida appeared to acknowledge Wall Street’s worries in other recent commentary, citing lackluster economic growth abroad as one factor that could complicate the Fed’s plan to push through with its steady pace of rate increases.
Traders heralded their remarks as the central bank making a dovish turn, pulling back expectations for several rate hikes in 2019. The fed fund futures market, where traders can bet on the direction of benchmark interest rates, now shows market participants forecast only one to two hikes next year, from projections for up to three hikes in place a month ago.
If Powell repeats his concerns over the global economy’s health and lists other downside risks to normalizing monetary policy, short-dated yields, which closely track the Fed’s hiking path, could retreat and steepen the yield curve.
Also check out: Traders betting on a dovish Fed have it all wrong: SocGen economist
But market observers say in Powell’s mind, the sharp correction in equities will weigh less than the U.S.’s low unemployment rate, which if allowed to continue to fall may eventually require a flurry of painful rate hikes to subdue the unleashed inflationary pressures coiled in an overheating labor market. To avoid such a panicked policy response, the Fed may see steadily raising rates as a better way of extending the U.S.’s economic expansion than standing pat, even if stocks fail to recover.
“Our sense is that Powell and Co. would be more willing to look through some excesses coming out of risk assets at this point in the cycle to avoid overcooking the economy,” said Ian Lyngen, head of U.S. interest rate strategy at BMO Capital Markets, in a note on Monday.
The U.S.’s unemployment rate stood at 3.7% in October, its lowest levels since 1969. And economic growth remains strong, with the U.S. projected to grow 2.9% this year.
If Powell sticks to the script of the need to tighten policy to ensure growth remains sustainable, the yield curve should flatten, said Lyngen.
Short-dated yields will maintain their ascent and lift borrowing costs, casting a pall over the economy. Against that bleak backdrop, long-dated yields will struggle to shift higher.
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Source : MTV
