22nd July 2019 – J. Patrick Bradley

Introduction

Federal Reserve (Fed) Chair Jerome Powell made the pilgrimage to Capitol Hill to deliver the semi-annual monetary policy testimony to both chambers of Congress. The chairman, along with the Federal Open Market Committee (FOMC) members, have turned increasingly dovish in the aftermath of weakness in financial markets at year-end 2018, when financial conditions tightened. At that time, the S&P 500 fell around 20% from the beginning of the prior quarter of 2018 to Christmas Eve, while the U.S. 10-year note hit a 5-year high of 3.3% on November 7, 2018. The market verdict was that the Fed had gone too far in its normalization policies, with rates too high and the balance sheet reduction potentially constraining U.S. economic growth—a view we also held. Those policies had boosted the U.S. dollar and had a global impact.

Now, financial markets have recently “lobbied” for a return to accommodative monetary policy, although the fundamental supports for an aggressive round of accommodation remain mixed. We have posited the Fed could start easing as early as July, so let’s look at several signals below to see to what extent they support Fed dovishness, or even serve as reliable indicators after years of unprecedented policymaking and market conditions.

The Guiding Signs

The recession signals. Today, the Fed’s policy rate stands at a range of 2.25-2.50%. The tightening over the course of four years has contributed to an inversion of the yield curve, as measured by the difference between the 10-year Treasury note and the 3-month Treasury bill. This inversion has typically harkened a recession. However, another yield curve indicator of recession—the difference between the 2-year Treasury note and the 10-year yield—remains positive ( Chart 1), albeit the curve has flattened dramatically. All told, the two yield curve measures of inversion tell conflicting stories: one measure is flashing recession, the other is not, yet both measures are a cause for market concern. The signal embedded in the yield curve may now be distorted by years of unconventional monetary policy, meaning the yield curve message may be not be the same one as in the past.

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