Powell’s stance and the inverting yield curve

“It’s no longer about the journey. It’s about the destination”

-John Farrell, Bloomberg

The plight of the Fed chairman is rightly summarized by market enthusiasts. The path taken by the Fed at this point is only a means to achieve the ultimate goal or the destination. Financial markets are going to call it the terminal rate - where the rates are finally going to be.

The Fed Fund Futures is now pricing a terminal rate of 5% and 5.25%. Okay! So, now that we’ve set the context, the Fed needs to increase rates by about 150 bps in future to ensure that they meet this terminal rate expectation.?

Let’s take a look at how things are panning out.

Terminal rate

One of the simplest ways to calculate the terminal rate is to look at the Fed Fund Futures Contract. The federal funds rate is the rate banks charge each other for overnight loans of reserves on deposit with the Federal Reserve.

The Fed uses the federal funds rate to control the money supply and cost of credit in the economy. Fed funds futures are derivatives based on the federal funds rate (the overnight interbank lending rate on reserves deposited with the Fed).

The terminal rate is moving northwards but at the same time it seems to slow down around April and May. This is where the market feels that the Fed has already taken the required rate hikes and met the spread to reach the peak of the terminal rate.

Job market

Surprisingly there is a constant rise in the average weekly earnings as shown in the Establishment data that is released this week. Labor market is strong and there are no signs of softening yet.

Yearly change in average hourly earnings is now consistent at 5% Now this makes the situation alarming and Mr. Powell clearly states that it won’t be possible to achieve the inflation target of 2% if the wage rise is happening at such a pace.

Workers who have changed jobs have seen their salary increase by 15.2% while those who stayed in the same job had a 7.7% rise.?

This is surely not the right recipe for deflation. In fact, what makes the situation worse is the real GDP growth rate is zero and the economy is still creating jobs every month.?

Central bank profits take a hit!

The Fed is known for making money for the US government. This reputation is now at threat after a decade.? The QE portfolio takes a beating and the interest on excess reserves to be paid to banks is now heading above 4%

The Fed created enough dollars through the QE program which is now sitting as cash piles with banks. Banks would need to lend them at a high interest rate. When they are not able to do it, the Fed steps in as the last resort. In other words, the Fed is now paying for the excess money supply that it had created during the QE.

Yield curve inversion

?A 10-2 treasury spread that approaches zero signifies a "flattening" yield curve. A negative 10-2 yield spread has historically been viewed as a precursor to a recessionary period. The 10-2 Year Treasury Yield Spread is at -0.49%, compared to -0.57% the previous market day and 1.12% last year.

Powell has a different take on the yield curve. He prefers considering an 18 month forward 3 year Treasury bill minus the spot treasury bill. This spread is on the verge of inverting.?

?????????Inflation is more sticky that the Chairman expected and rate hikes may not be linear considering the challenge presented. Powell is no longer prioritizing the “soft landing” but it’s the pain of inflation that’s bothering the Fed.

Disclaimer - The views expressed in this article are of the author and do not represent the firm’s views.