Recession signal may increase pressure to cut
A red flashing recession indicator in the bond market only increases the pressure that the Federal Reserve will face when it meets next month to deliver what the markets expect will be a new interest rate cut.
The spread between the returns on the two- and 10-year Treasurys turned Wednesday morning as the debt with a shorter duration rose above the reference rate level. It is a classic recession indicator, and forecasts the last seven periods of negative US growth.
The Fed had already expected to cut its equity rate by a quarter of a percentage point. But with economic signals becoming more and more negative, the central bank will surely question whether the central bank will act even more aggressively.
A 25 basis point move "is still our cause," said Bill Merz, head of interest rate research at US Bank Wealth Management. "But the odds of a more aggressive cut increase the longer we are in this period of extreme volatility, uncertainty, negative sentiment and reverse curves."
Fear that a global downturn could cause the US in recession has fueled the fuel market turmoil, with large averages falling more than 2% Wednesday amid the bond market's tumble. The inversion had actually turned to afternoon trading, but it was still enough to trigger fear on Wall Street following a series of negative economic data from Europe.
The signal is still a "yellow flag"
Despite the shock to the markets, the Fed is still expected to take a more gradual approach to interest rate cuts in the future.
Market pricing Wednesday pointed to only a 1[ads1]9% chance of a 50 basis point cut at the September Federal Market Market meeting, according to CME. Businessmen expect a further decline in October, followed by a further move late this year or early 2020.
The investment in the yield curve was not seen as an automatic economic downturn, despite the strong predictive power of late. Market experts see this inversion as at least partially driven by some elements that have not been present in previous cases.
"At least this is a yellow flag," said Jason Draho, head of America's asset allocation at UBS Global Wealth Management. "There are aspects of what happens that give us a little more pause about how negative a signal this is, mostly due to technical factors."
One of these factors, which Fed officials have cited at different times when discussing the flatness of the yield curve, is the term premium.
This is the compensation investors require to hold assets as bonds. The term premium for the 10-year note has fallen to minus 1.22, according to a New York Fed estimate that is the lowest on the record. In other words, investors demand a very low premium and put further downward pressure on returns.
"I think they want to get the curve not to be reversed," Draho said. "If things get worse over the next few weeks in terms of financial data, in terms of trade tensions, they might be able to go 50 basis points in an attempt to get ahead of it. Right now, I think they're gradually moving in that direction. "
To be sure, the markets are far from sanguine about the inversion and what it will mean for a Fed split between those favoring a more cautious approach that leaves policy makers with more ammunition in the event of a steeper downturn against those who want to come out ahead of potential problems ahead.
Market voices have been pushing for lower prices, just nine months after the latest increase when worries are going over where things are going.
David Rosenberg, chief economist and strategist at Gluskin Sheff, warned clients in a note Wednesday that "people [who] will continue to dream up ways to tell you to reject the flat form message on the return curve when they are instead you should decline. " [1 9659002] Should this message persist, it is likely to get the Fed's attention.
"The yield curve has made it pretty clear that short-term interest rates are too high," said U.S. Banks Merz. "We see a lot of uncertainty and negative attitude in the market. That, combined with the signal the curve has sent for some time, can certainly influence the Fed to be more aggressive in its approach."
