How Concerned Is The Fed With The Yield Curve?

After another week of yield curve flattening, we now have the 2s-10s curve in US Treasuries at just 43 basis points. Fed members will be looking at the data in front of them and wondering what market participants are seeing that they don’t. The economic data shows continued confidence in the ongoing recovery and inflation merely hitting target, with very little in the way of warning signs of anything more sinister. The problem is the yield curve says otherwise. In short, the pace of flattening suggests market participants are thinking the peak in markets is close and the best conditions will soon be behind us, so consequently gentle risk reduction is required.

This presents a dilemma for the Fed. They certainly don’t want to encourage too much risk taking, but a flat yield curve is a good predictor of recession – even when the data says otherwise – and should we reach that flat inflection point the outcome could be self-fulfilling. So do they ease the pace of tightening and allow inflation to run a little hot? Or do they simply comment on the dangers of a flat curve and proclaim it is unjustified?

St Louis Fed Governor James Bullard’s presentation on Friday stated as much, though he is a well-known dove and not currently a voting member. However, we do have a big calendar of Fed speakers this week and we shall certainly be listening out for hints as to what the Fed plan to do about this dark cloud on the horizon. The pick of the speeches is probably San Francisco Fed Governor John Williams’ speech on Wednesday evening in Minnesota.

If the Fed does nothing new, and continues with its current pace of hiking (markets are now pricing in three more this year), then a flat yield curve within the next 12 months is increasingly likely. We expect the rhetoric to be far more proactive over the near-term, and the shape of the curve is likely to be a key topic for the FOMC and for the wider market in the months to come.