As Fed Says on Track, Narrowing Yield Curve Could Complicate Debate

As Fed Says on Track, Narrowing Yield Curve Could Complicate Debate

And the reason has something to do with an occurrence that is not exactly in the everyday investor's lexicon: an inverted yield curve. When the yield curve inverts, it means the two-year notes pay bondholders more in interest than 10-year notes do, something that's both rare and counterintuitive. "I think the dollar can be in correction-mode in a yield-curve inversion environment".

The Treasury "yield curve" can be seen as a proxy for investor sentiment on the direction of the economy. The Big One will be when 2-year and 10-year Treasury rates swap places, and bond traders are doing their darnedest to make it happen soon, as Robert Burgess points out. That's because the longer it takes a bond to mature, the higher the yields investors demand as a protection against inflation.

"It's a sloppy predictor because at some point after yield curve inversion you could get a recession that could be one year, two year, three years", said Nicholas Colas, co-founder at DataTrek Research in NY.

Typically, the yield curve slopes upwards over time, especially in times of strong economic growth.

Another big recession indicator is the recent weakness in housing.

Global stocks tumbled on Tuesday as a flattening Treasury yield curve sparked recession warnings, while optimism sharply waned that the United States and China would quickly resolve their trade dispute.

In separate remarks on early December 3, Fed vice chair Randal Quarles said the central bank, while "data dependent", was following a strategy that would not be thrown off course by "every wavering" of economic statistics.

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"The Federal Reserve may slow down the pace with which it hikes interest rates, but it won't lower rates yet, so the likelihood there will be an inversion of these is low", Sera said.

"We should be data dependent but not reacting to every wavering of the needle across the dial..."

Weakening global growth, trade war fears, higher interest rates, and wariness over the extent of Federal Reserve tightening are weighing on markets.

Though it is not certain the narrowing in spreads is related to doubts about economic growth, alternate explanations would not necessarily be helpful to the Fed either.

Benchmark US Treasury yields fell back below 3 percent on Monday, and yields on two maturities at the front of the curve dove below longer-dated 5-year notes for the first time in more than decade, as risk appetite sparked by a US-China trade agreement faded. It has a scarily accurate track record of predicting economic recessions, which in past decades have arrived six months to two years after an inversion.

Cornerstone Macro analyst Roberto Perli attributed the drop in 10-year yields to "two main culprits..."

The outlook for USA growth, by contrast, he said remained strong. Karl W. Smith suggests the market is pricing in lower Fed rates in the future, either to end a recession or to prevent one.

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