• Economy

7 days of Economics - USA, Fed: Market considers tightening cycle is well advanced

William De Vijlder
William De Vijlder
Group Chief Economist BNP Paribas
  1. Recent Federal Reserve research shows that the slope of the short end of the yield curve is a more reliable indicator than the commonly used difference between 10-year and 1 or 2-year US Treasury yields
  2. In a similar vein, we can look at the difference between the forward 3-month LIBOR rate and the spot rate. This difference has increased as of late
  3. However, the level and shape of the entire forward curve show that the market is of the view that the Fed tightening cycle is well advanced 

Is the growing media coverage of the US yield curve flattening the equivalent of a summer hit on the radio? It is played many times per day, initially you like it but you end up getting bored by it. By now everybody knows that US recessions are generally preceded by a curve inversion so what else is there to be said? Perhaps we should shift our focus a little bit. 

One recent interesting contribution came from the Federal Reserve showing that the near-term forward spread does a better job in anticipating downturns than the long-term spread (e.g. 10-year minus 2-year). The former is calculated as the difference between the current implied forward rate (on Treasury bills) six quarters from now and the current yield on a three-month Treasury bills. It reflects market expectations about the near-term monetary policy stance: when it flattens it indicates that the market thinks the pace of tightening will slow. An inversion would imply an expectation of policy easing over the next 6 quarters. Such an easing, after a tightening cycle, would reflect concern of the central bank about an upcoming slowdown and this makes it also intuitively clear why this indicator provides a better signal than the long-term spread. 

Along the same line we can look at the USD LIBOR rates and compare the difference between the 3-month rate in 6-months (so a shorter horizon than in the Fed study) and the 3-month spot rate. Chart 2 (see Ecoweek) compares the evolution of this difference -the slope of short end segment of the LIBOR curve- to the federal funds rate. The swings in the slope are sometimes considerable. In 2000, the market moved from expecting further tightening to anticipating easing in a matter of months. In 2006 the curve inverted although the economy entered a recession only at the end of 2007.

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