The Fed last Wednesday brought its 3-year drive to tighten monetary policy to an abrupt end, abandoning projections for any interest rate hikes this year amid signs of an economic slowdown, and saying it would halt the steady decline of its balance sheet in September.
The yield curve between 2-year and 5-year notes inverted further than it had been and is now approaching levels at which the Fed has in the past cut rates.
The spread between US 3-month T-Bills and 10-year T-Notes yields Friday also turned negative for the 1st time in over a decade, triggering a warning that if the inversion persists a recession may follow in the next 1-to-2 years.
In the past the inversions and subsequent rate decreases have occurred against a backdrop of very adverse events, including the savings and loans crisis in Y 1989, the implosion of the NASDAQ stock index in Y 2000 and the US housing decline in Y 2006.
Nothing like that is happening now or on the horizon
There is no obvious comparable today though trade tensions with China and Britain’s exit from the European Union are risks that could threaten the US economy.
A worsening employment picture could also prompt the Fed to act. A rise in unemployment claims has preceded curve inversions and rate cut moves in the past.
If long-dated Treasury yields continue to decline the Fed may cut rates as a proactive move to stave off recession. This has been effective before. Rate cuts in Ys 1995 and 1996 helped to push out a recession until Y 2001.
The Fed has cut rates prior to the last 3 recessions, after adopting a funds rate targeting policy in Y 1982.
In these cases, the Fed cut rates on average about 8 months after the 3-month, 10-year yield curve 1st inverted, which in this case would imply a December cut.
“While our economists believe that the Fed’s next move will be a 25bp hike in December, not a cut, we see room for markets to put a higher probability on a rate cut in 2019 if economic data struggle over the coming months,” Morgan Stanley said in note Monday..
We believe a cut will happen by September, as the Fed needs to negate its hike from December, which we see as a “mistake” given a weakening economic outlook.
Interest rate futures traders are currently pricing for an approximately 60% chance of a rate cut by December, according to the CME Group’s FedWatch tool.