The US yield curve, watched nervously by investors for signs of an impending recession, steepened in the past week by the most in almost three years, reflecting optimism that a rate cut by the Federal Reserve will keep the US economy growing.
The difference between three-month and 10-year Treasury yields — which has turned negative, or “inverted”, before every US recession of the last 50 years — briefly nudged back into positive territory on Friday.
The measure ended the trading week at minus 1.6 basis points, from minus 19 basis points a week earlier, the largest change over five trading sessions since the period after Donald Trump was elected US president in 2016.
Meanwhile, the US stock market rose 0.8 per cent this week, with the S&P 500 index of large companies closing above 3,000 for the first time ever on Friday.
The moves served as vindication of sorts for the Fed’s tilt toward looser monetary policy, seen as insurance against further deterioration in the US economy after financial markets had been communicating concerns about the outlook.
Fed chair Jay Powell signalled clearly this week that the central bank will cut rates at its next monetary policy meeting at the end of the month, citing economic risks such as the US-China trade war, even as he painted a picture of a broadly healthy US economy.
Despite the growing optimism shown by the yield curve, some investors are still cautious. Jobs growth was strong in June and consumer price inflation rose at a healthy clip, but there was underlying weakness in manufacturing data and weak inflation expectations. US 10-year break-even inflation rates, a market measure of inflation expectations, rose 8 basis points to 1.78 per cent this week but remain well below the Fed’s target of 2 per cent.
“The equity market is rallying aggressively because of the thought that the Fed is going to make sure the economy is doing well,” said Shawn Matthews, the chief investment officer of Hondius Capital Management. “But they are pushing on a string. A 25bp rate cut doesn’t make an economy better, but it does make financial assets better.”
In testimony to Congress this week, Mr Powell noted that his fellow Fed officials believed “the case for a somewhat more accommodative monetary policy stance had strengthened”.
Investors see zero chance the Fed will hold rates steady at its next meeting ending on July 31. Markets are pricing in an 81 per cent chance of a 25bp rate cut, according to futures prices compiled by Bloomberg data, and there are still investors betting on a 50bp cut. Traders are also betting on at least one more cut before the end of the year.
While some investors see the Fed’s move as unjustified given stronger US economic data, the rosiest data points have been overshadowed by tumbling bond yields and a yield curve that has been inverted since the end of May.
“There is really no good excuse for cutting rates at all,” said David Kelly, chief global strategist at JPMorgan Asset Management. “They’re doing so to avoid a market meltdown.”
Seema Shah at Principal Global Advisors said: “The Fed is cutting rates not in response to the economy, but in order to avoid a market fallout . . . The Fed put itself in a corner. We’ve had a run of stronger data which at any other time would not have led them to cut rates.”