There is no escaping the bear-flattening of the yield curve.
Although the Federal Reserve had the unique opportunity to take control of the market narrative last week, it decided not to do so. The central bank catches up with markets as sustained inflation becomes a more significant problem. In our view, this posture will cause the Fed to become more aggressive throughout the year, creating the perfect environment for a policy mistake that might derail the economic recovery.
The key points that emerged from last week’s FOMC meeting can be summarized as follow:
- “The Committee views changes in the target range for the federal funds rate as its primary means of adjusting the stance of monetary policy."
- The Fed is getting ready to hike rates at its March 16th meeting and reduce its balance sheet soon after.
- Tapering of bond purchases will continue as announced in December, leading to zero purchases by March.
The first point is pivotal, and it can be linked to last week's sharp flattening of the yield curve. By using interest rate hikes as the primary tool of tightening the economy, the front part of the yield curve will shift higher. In contrast, the long part of the yield curve will remain compressed amid fears of an economic slowdown. We see this as one of the main threats for markets in 2022 because investors might need to price for even faster rate hikes than what they have done since the beginning of the year. After all, Powell said there is room to raise rates without hurting the labor market. Investors caught the message, and while before the FOMC meeting, markets priced four rate hikes this year, we are now looking at five. Hence, 2-year yields hit their highest level since February 2020 and the 2s10s spread tightened by 20bps to 60bps, the lowest since October 2020.
Although the runoff of the Fed's balance sheet seems to take a secondary role in monetary policies, we continue to believe it will cover a critical role in the future. At the press conference, Powell mentioned that the Fed might be more aggressive in reducing its balance sheet than in previous instances. It would apply enough upward pressure to long-term yields if that were true, preventing the long part of the yield curve from collapsing due to growth concerns. The market is currently underestimating balance sheet policies. If its runoff is more aggressive than expected, it could force markets to pull back on rate hikes expectations. Indeed, if bold enough, a balance sheet reduction could help the central bank avoid proceeding with as many hikes as the market is currently pricing. However, the fact that the Fed did not end tapering last week makes the market doubt the Fed’s intentions and contributes to a steady flattening of the yield curve.
As the yield curve bear-flattens, signs of an inversion, thus a policy mistake, increase. So far, the spread between 7-year and 5-year yields is on the verge of inverting, as it shrunk down to 2bps last week.