While not the media and academia’s preferred tracker of looming recessions, the front-end of the Treasury curve has now inverted…
…for the first time since June 2007.
All of this got Bloomberg’s Cameron Crise wondering what is the typical Fed policy move is in the year after 2s-5s inverts?
It turns out that there is some precedent for further tightening, but only by a maximum of 100 bps…a pretty modest pace by the standards of history.
More to the point, since 1985 the Fed funds rate has never risen (on a 1-year forward time horizon) when 2s-5s was inverted by more than 12 bps. Clearly we are some way from that, but it’s going to be hard to argue from an historical perspective that the apparently inevitable front-belly inversion won’t in some way mark the beginning of the end of the Fed policy cycle.
Yields remain very modestly higher on the day but are sliding rapidly from overnight highs…
Additionally 2s5s is back below 1bps…
And Breakevens are collapsing…
And as we laid out in great detail before, this is a big deal.
As JPM’s Nikolaos Panigirtzoglou wrote, an inversion at the front end of the US curve is a significant market development, not least because it occurs rather rarely, and has happened only three times over the past two decades: in 2005, 2000 and 1998 – all periods in time preceding major market busts.
While redundant, JPM explained that “such inversion is also generally perceived as a bad omen for risky markets” and highlighted that the two potential explanations are either markets pricing in a Fed policy mistake, or pricing in end-of-cycle dynamics.
Fast forward to today, when 8 months later, Panigirtzoglou writes in his latest Flows and Liquidity commentary that since then, not only has this inversion worsened, but it has shifted forward, and since the middle of November, the forward curve is inverted between the 1-year and the 2-year forward points.
This shift forward in Fed policy reversal expectations is in line with historical experience. As JPM wrote back in April, the 3y-2y forward rate spread had historically led the 2y-1y one, and this has now occurred since mid-November.
What does this mean in practical terms? Simple: the latest curve inversion implies that markets are now pricing in a peak in the Fed policy rate in end-2019 rather than during 2020 previously. JPMorgan shows this in Figure 2, which depicts the forward curve of the 1-month dollar OIS curve currently vs. its snapshot at the beginning of October before the equity market correction.
Not only has the market-implied path of policy rate expectations shifted downward in the aftermath of the equity market correction, but the whole curve has shifted forward. And this week’s comments by the Fed Chairman appear to have reinforced these policy reversal expectations with the 2y-1y forward rate spread inverting further to below -3 basis points.
Of course, as we discussed extensively in April, such pronounced shifts forward in Fed policy rate reversal expectations has also traditionally been associated with end-phases of the US monetary policy cycle. In the 2000 monetary policy cycle, the 3y-2y forward rate spread of the 1-month OIS rate turned negative in February 2000. And as JPMorgan adds, the 2y-1y forward rate spread turned negative four months later in June 2000. The Fed delivered the last hike in May 2000.
In other words, from a timing point of view, the last hike of the Fed at the time almost coincided with the inversion of the 2y-1y rate forward spread. Incidentally that also marked the bursting of the dot com bubble, as the US equity market had started declining at roughly the same time in June 2000. The subsequent equity market correction induced the Fed to start cutting rates in 2001.
Fast forward to the next rate hike cycle, when in the 2006 monetary policy cycle, the 3y-2y rate forward spread of the 1-month OIS rate turned negative rather early in August 2005. The 2y-1y forward spread turned negative ten months after in June 2006. Similar to the 2000 cycle, the last hike of the Fed at the time in June 2006 coincided with the inversion of the 2y-1y forward rate spread. There was one material diference to the 2000 cycle: the equity market had started declining much later in October 2007 when the Fed started cutting rates.
Rather concerningly, here JPM notes that although it is still early to draw conclusions, the lags from the 3y-2y inversion to the 2y-1y inversion and the September peak in the US equity market appear more consistent with the 2000 rather than the 2006 cycle.
Now as readers may recall, when the 3y-2y forward spread inversion first emerged last April, JPM argued that an inversion at the front end of the US curve “was a bad omen for risky markets.”
So, perhaps not unexpectedly, the ensuing 2y-1y inversion and shift forward in Fed policy rate reversal expectations is, according to JPMorgan, “worsening this bad omen.”
Why? Because in even more bad news for the BTFD crew, the lesson from the previous US monetary policy cycles is that a sustained recovery in equity and risky markets has tended to occur only after the inversion disappears and the front end of the US curve, in particular the 2y-1y forward rate spread, resteepens.