Fed presidents disagree on key bond market signal

Over the summer, investors put a gimlet eye to returns on US Treasuries, examining them for signs of a recession. The Fed has been watching, too, with some disagreement over what it is seeing and how to respond. 

In appearances this week, two Fed presidents laid out different arguments for the recent dramatic fall in Treasury yields and the concurrent inversion of the yield curve — a traditional harbinger of recession, in which shorter-term interest rates are higher than longer-term ones.

Eric Rosengren, president of the Boston Fed, attributed the developments in the Treasury market to economic weakness abroad, which means there is less reason for concern at the US central bank. Robert Kaplan, president of the Dallas Fed, blamed concerns over domestic growth, highlighting the need for the Fed to cut interest rates.

Their disagreement lies at the heart of the central bank’s debate about what to do at its next policy meeting, later this month, where Fed chairman Jay Powell is facing a divided committee. Markets have priced in a 25 basis point cut in the Fed’s policy rate, the same size as its cut in July, which drew two dissensions from committee members.

Yield curve inversions have occurred before each US recession of the last half century, so they serve as an indicator that something bad is coming. The spread between the three-month bill and the 10-year note now sits at minus 40 basis points. That is off recent lows, but still around levels last seen in March 2007. 

Auguring from inversion has a weakness, though. It can suggest that a recession is coming. It cannot say when. In a note on Thursday, analysts at Bank of America Merrill Lynch found that a recession could start as soon as eight months after an inversion. They also found that it could take as long as five years.

Speaking at a Stonehill College in Massachusetts on Tuesday, Mr Rosengren said this inversion is different. In the past, he explained, most inversions had been created by the Fed itself, as it raised short-term rates at the end of an expansion to slow growth and prevent inflation. 

What is driving this inversion, he said, is the drop in longer-term yields, which in turn reflect “challenging economic conditions in much of the rest of the world”. Mr Rosengren’s argument is similar to that made by the Trump administration: global investors are buying anything with a dollar sign, both for security and better returns. 

“Basically this is the best game in town across the globe,” Peter Navarro told Fox Business News last week. For longer-dated debt, he said, “we’ve got money flowing into the bond market that’s pushing up prices, pushing down yields”. Mr Navarro, who runs the White House’s trade and industrial policy, then argued for the Fed to lower rates on the short end as well.

Animation showing how the US yield curve has changed over the past 12 years. US Treasury yields have fallen and recently the curve has 'inverted' denoting that a recession may be imminent

That is not Mr Rosengren’s preferred path. In July, he dissented from the Fed’s decision to lower its policy rate by a quarter point. The yield curve had not changed his mind this week. “Financial market indicators,” he said in his speech, “remain benign.”

Mr Kaplan reads in the yield curve a simpler, more traditional story: lower yields on US Treasuries in the future show concern over lower US growth in the future. “I think the whole curve moving down, particularly at the long end, tells me there’s a lot more pessimism about future growth prospects,” he told the Financial Times on Wednesday.

Mr Kaplan has been watching a different inversion: between the Fed’s main policy rate and yields on all US government debt. The fed funds rate of 2-to-2.5 per cent is now above the entire Treasury yield curve, including the 30-year bond, as it was in 2006. If that situation persists, Mr Kaplan said, “it will create its own set of distortions and challenges, which may seem innocuous for a time, but I think eventually will create issues which tighten financial conditions”.

Mr Rosengren is a voting member of the FOMC this year. Mr Kaplan, an alternate this year, will vote in 2020. 

“For those who say, ‘Well, there’s reasons and this time is different,’ that may be true,” said Mr Kaplan, referring to the Treasury yield curve inversion, “but my experience in my career has been trying to make explanations with ‘this time is different’ haven’t gone well.” 

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