The Fed Isn’t at the Mercy of the Yield Curve

Message received loud and clear. Federal Reserve Chair Jerome Powell had his foghorn out on Tuesday blaring that there is nothing, repeat nothing, to stop policymakers from yanking interest rates up in half-point steps. His hawkishness prompted the yield curve to flatten to levels not seen since 2016, setting off alarm bells about a potential inversion - where shorter-dated levels rise above longer-term rates - signaling recession.

But looking at the wider picture of the predictive power of yield curves, it is really only when they invert significantly and for several quarters that the recessionary warning holds up. A brief flirtation can often be a false signal. And while economists surveyed by Bloomberg see a greater risk of the U.S. economy suffering two quarters of shrinkage in the coming year, the chances of recession are still only at 20%.

Whisper who dares, but this time is also different. With a Fed balance sheet of $9 trillion after more than a decade of quantitative easing, there are more tools at the central bank’s disposal than just hiking the Fed funds rate. By owning so much of the bond market, it can steer longer-dated yields by choosing which maturities to buy and sell as it unwinds its bond-buying program.

Powell instructed us that his preferred way of looking at the Treasury yield curve is not focused on the two-year to 10-year spread, which is rapidly moving toward zero. Instead, he favors the shorter end of the money-market curve, where there’s still a 180 basis-point differential to longer yields. The size of that gap suggests recession may not be imminent, and explains why Powell stressed the tightness of the labor market as explaining why he is prioritizing the need to curb inflation over the risks to growth.