- Fed Chairman Jerome Powell’s preferred bond-market indicator says a recession is on the way this year.
- It’s the spread between the yield on three-month Treasury bills and their expected yield in 18 months.
- Powell has touted the predictive power of the gauge in previous statements.
Fed Chairman Jerome Powell’s preferred bond-market metric is signaling that a recession is certain this year and that rate cuts are also coming.
The spread between the current yield on three-month Treasury bills and their expected yield in 18 months is now inverted by a record 134 basis points.
That’s more than the previous record set in January 2001, about two months before a recession began in the US, according to Bloomberg.
Here’s how Powell described the bond-market indicator in March 2022:
“Frankly, there’s good research by staff in the Federal Reserve system that really says to look at the short — the first 18 months — of the yield curve. That’s really what has 100% of the explanatory power of the yield curve. It makes sense. Because if it’s inverted, that means the Fed’s going to cut, which means the economy is weak.”
An inverted yield curve suggests investors aren’t confident about future returns, and it’s a classic warning for a economic downturn.
Additionally, to Powell’s point, the bond market is saying that the central bank will reduce interest rates in the coming 18 months, given that the near-term yields are higher than where investors expect them to be later on.
On Wednesday, the Fed made a quarter-point interest rate hike, and markets began pricing in higher odds that the central bank would cut rates as soon as July, Bloomberg data shows.
The Fed’s messaging, however, contrasted with market expectations, as Powell said interest rates will still remain elevated through the year. But he also noted the recent bank turmoil with Silicon Valley Bank, Signature Bank, PacWest, and others could help the Fed achieve its goals by tightening credit conditions overall.
“If the US economy continues to rumble along as it has the last few quarters, interest rates will remain high,” DataTrek Research’s cofounder, Nicholas Colas, wrote in a note Thursday. “If the current mini-crisis in the banking system begins to crimp growth, the Fed will still want to see proof that this phenomenon is indeed working like a Fed rate hike to reduce inflation.”
Meanwhile, after the Fed’s latest rate hike, Bill Ackman warned that the US economy is heading for a “train wreck”, whereas former Treasury Secretary Larry Summers said, despite the banking tumult, more rate hikes may ultimately be necessary.