Economists at the largest bond fund manager in the world predict the Federal Reserve would hint at a respite for its rate-hike cycle once the yield curve inverts, a phenomenon that has preceded every recession since World War II.
That’s according to Joachim Fels, global economic adviser for Pimco, who says once short-term yields push above their long-term peers, the inflection point would send shivers through the bond market and all across Wall Street amid concerns the Fed could prematurely end the second longest economic expansion in the U.S.’s post-war history.
Triggering a one-two punch of a selloff in risky assets and tighter credit conditions, the inverted curve would force the central bank to “change gears and signal a pause in the hiking cycle to avoid a lasting curve inversion,” said Fels. The yield curve would thus “become part of the Fed’s reaction function.”
Fels measures the yield curve through the spread between the 3-month London interbank offered rate, a benchmark for trillions of floating-rate loans, and the 10-year Treasury yield TMUBMUSD10Y, -0.29% By this gauge, the curve could invert by the end of this year if the central bank raises rates two more times this year, as a slight majority on the Fed panel has signaled, and the 10-year yield doesn’t budge from current levels, Fels said.
Read: 5 key ways Wall Street and economists think about the yield curve
The Fed’s push to raise rates at a gradual pace has lifted short-term yields while the long end hasn’t significantly built in its own inflation risks, at least not at the same clip. The result is a flatter curve. The yield spread between the 3-month Libor rate and the 10-year note currently stands at around 50 basis points. On the more popular measure of curve’s slope, the yield gap between the 2-year note TMUBMUSD02Y, -0.47% and the 10-year note sits at a much narrower 24.3 basis points.
With the strong growth outlook compelling the central bank to raise rates, investors have suggested the only reason the central bank might pause its tightening cycle in the near future could be a yield curve inversion. At the same time, market participants say the central bank would be wary of showing too much deference to the yield curve, at the expense of their own staff economists’ models and forecasts, said Tom Graff, head of fixed income at Brown Advisory.
Opinion: The bond market goes its own way
Yet senior Fed officials have made repeated references to the bond market indicator in the last few weeks, hinting at a nervousness in the central bank’s ranks over the curve’s predictive powers.
Atlanta Fed President Raphael Bostic, St. Louis Fed President James Bullard, Philadelphia Fed President Patrick Harker and Minneapolis Fed President Neel Kashkari have all said at one time or another that the central bank should avoid trying to invert the yield curve.
Read: Yield curve’s return to flattest levels in decade raises question over its significance
So far, the most important person at the Fed seems unwilling to back down.
Chairman Fed Powell in his testimony on Capitol Hill Tuesday deflected questions about whether the central bank would blink in the face of the yield curve’s nearing an inversion. Powell said he saw the inverted curve as a reflection of the long-term neutral rates, the theoretical level at which monetary policy neither stimulates or slows the economy.
Also check out: Fed will be key to preventing yield curve’s recession prophecy from coming true: investor
