The bond market is watching for a mistake from the Fed. Check the yield curve.



Text size

Federal Reserve Board Chairman Jerome Powell.

Brendan Smialowski / AFP via Getty Images

The bond market is signaling that the Federal Reserve will soon have to sharply raise interest rates and that such a move could hurt economic demand.

Changes in bond yields suggest that this year’s surge in inflation has lingered long enough to prompt the Fed to raise interest rates more than once over the next year. The yield on the 2-year Treasury debt, which reflects rate expectations, fell to 0.7% against 0.46% since the end of October. This implies a tightening of monetary policy which would reduce inflation, but also reduce economic demand in the longer run.

As a result, yields on 10-year debt moved in the opposite direction, falling to 1.53% from 1.7%, the second half of 2021 high reached at the end of October.

This means that the difference between long-term and short-term returns – the yield curve – has narrowed, often indicating that markets view the Fed’s anticipated policy as negative for economic growth. The spread between 10- and 2-year rates fell to 0.83 percentage points, well below its 200-day moving average by almost 1.5 points.

The rapid flattening of the yield curve does not imply that the Fed will raise rates once in 2022, but that it will do so several times and quickly. Some investors see this as a potential mistake, which the economy probably couldn’t handle. “A Fed policy error is a risk we continue to monitor,” wrote Lawrence Gillum, fixed income strategist for LPL Financial.

Granted, not everyone thinks market movements signal a significant slowdown. Dynamic Economic Strategy noted on Wednesday that for most of the 1980s, the spread between 10-year and 2-year Treasury yields was less than 1 percentage point. Currently, “we don’t expect the yield curve to flatten enough to signal a recession,” wrote John Silvia, founder of the research institute.

Yet the decline in the yield curve has worsened over the past week. This is mainly because the Fed has made it clear that it may move faster than expected to end the bond buying it has used to support the economy during the pandemic. Raising interest rates would be the next logical step in the fight against inflation.

The fall in the yield curve “may be a sign that the Fed will not be able to raise rates too much before it has a negative impact on economic growth,” Gillum wrote.

Corporate bond prices also reflect concerns. A Bank of America investment grade corporate bond index now has an overall yield that is 1 percentage point higher than Treasury bonds – the biggest spread since March, according to data from the St. Louis Fed -, which indicates that investors are demanding larger payments to cover the risk of lending to companies rather than to Uncle Sam.

Investors who are now watching slowing economic growth and Fed policy changes may soon receive some clarification on these matters. The Fed’s monetary policy committee is due to meet next week, December 15-16.

“The Fed’s meeting next week is important and hopefully will help calm the markets,” Gillum wrote.

Investors in stocks, as well as in bonds, appear worried. the

S&P 500

fell 4% from its all-time high at the end of November, although it has now regained almost all of the lost ground.

“If we get to the start of the new year and we’re still in a very flat yield curve environment, it’s going to raise some eyebrows that there may be an economic slowdown,” Tony Bedikian, Head of Global Markets at Citizens Bank, said in October.

Write to Jacob Sonenshine at [email protected]



Comments are closed.