The US curve inversion has already begun – DiMartino Booth

Market data don’t speak to full employment right now. Inflation expectations would be rising. They don’t speak to the 4 or 5% GDP growth Larry Kudlow expects either. Instead we should be wary of potential stagnation, even recession. And a Fed that continues to increase rates into downbeat inflation expectations is one that risks overtightening.

At last check, the most-watched spread in the world – that between the 2-year and 10-year Treasuries – had flattened to 54 basis points, or hundredths of a percentage point. Yes, Virginia, tariffs do lead to economic slowdowns.

And yet, the Fed seems intent to keep hiking. That’s what happens when wage inflation appears to be building, which is exactly what was communicated in the latest jobs report that showed workers are finding jobs at the fastest pace in nine years. The easier it is to get a job, the more employers are willing to pay up for workers. I’ll chime in on the inflation debate next week ahead of Powell’s first FOMC meeting.

Until that time, divining the future by peering into your economic crystal ball will remain a hugely frustrating endeavor.

-Danielle DiMartino Booth

That’s the quote I found most interesting in the latest newsletter from Money Strong founder Danielle DiMartino Booth. As you know, I’m not concerned about 54 basis points. But I am afraid that “the Fed seems intent to keep hiking” as Danielle put it. The worry is that the Fed misses market signals of economic slowing. And since policy acts with a lag, it would overtighten and create a recession.

Inflation expectations curve is inverted

I do feel like Danielle buried the lead though. Hidden in the data from this past week’s post is, for me, the first market signal to worry about. Danielle writes:

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For my money, the future is all about the curves. The inflation curve has already inverted, as in the yield on 2-year inflation breakevens is above the yields on 5-year, 10-year and 20-year inflation breakevens. At least as far as recession-predictability goes, the inflation curve inversion must precede that of the nominal Treasury yield curve.

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If inflation breakevens are lower the further out you go, that’s not bullish for growth. Here’s what I’m seeing:

  • Increasingly people expect 4 hikes in 2018 and more in 2019.
  • And short-term rates are rising in line with raised interest rate expectations.
  • But long-term rates have stagnated, even started falling.
  • Now add, falling inflation aka disinflation to the mix given breakevens

What does this tell you?

My model says the Fed, as monopoly supplier of reserves, dictates the short end. It bullies the bond market into line on short-term rates. After all, it controls the federal funds through its monopoly reserve power. But, long-term rates are more fluid because the future is uncertain. And an inflation curve inversion says inflation expectations have diminished. It says inflation won’t be a problem to contend with.

That doesn’t speak to full employment. Inflation expectations would be rising. It doesn’t speak to the 4 or 5% GDP growth Larry Kudlow expects either. Again, inflation expectations would be rising. Instead it speaks to stagnation, even recession.

A Fed that continues to increase rates into these downbeat expectations is one that risks overtightening.

I am going to leave it there. Danielle’s latest note for subscribers is here.

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