On Wednesday last week, the Federal Reserve raised its target rate by twenty-five basis points to 5.00% – 5.25%. The pace of the current hiking cycle would suggest economic growth and inflation are accelerating. However, market-based indicators of those measures do not confirm that view. If long-term expectations for economic growth and inflation were accelerating, we would expect to see yields at the long end of the curve increase. The 10-year Treasury yield closed on Monday at 3.59% and moved down to 3.38% on the day of the rate hike. By the close on Friday, it was at 3.44%.
The U.S. Treasury yield curve inverted further as the 3-month and 6-month remained policy-dependent, while the long-end declined. In a positive economic environment, the yield curve should be upward sloping, reflecting an expectation for an acceleration in economic growth and inflation. In key parts of the curve, like the 3m10y spread, we saw a new record low of -189 basis points on Thursday. Historically, the relationship between these two parts of the curve has been a useful indicator of a negative economic environment ahead.
Another market-based indicator of economic expectations is the Near-Term Forward Spread, one that Fed Chairman Jerome Powell has said he relies on to determine economic weakness. The NFTS measures the difference in the expected 3-month Treasury yield eighteen months from now versus the current 3-month Treasury yield. This indicator has been inverted since November of last year and made a new cycle low last week on Thursday.
Additionally, on the inflation front, five and ten-year breakeven rates have continued to move lower. The five-year breakeven inflation rate has declined 140 basis points from its cycle peak to 2.19%. The ten-year breakeven also came down from its cycle peak of 3.02% to 2.21%. This is another indication that the markets’ expectation for an acceleration in inflation has declined.
One of the more concerning dynamics in this cycle is how low the peak in the 10-year yield would be if the economy does continue to decelerate and long-end rates decline further. The long-term look at the 10-year yield versus the target rate shows that despite several hiking cycles, the 10-year has continued to drift lower over time. With a rapid increase in the Fed Funds Rate, peak inflation at 9.0% in July 2022, and GDP accelerating 12.5% y/y in 2Q21, the 10-year yield should have theoretically moved much higher. We believe this setup is an indication of how weak economic growth and inflation expectations are relative to history.
Whether this is the last hike or not, we believe the economic cycle ultimately determines the path of long-end rates. We will continue to monitor this longer-term downward trend in yields as it will likely have broad implications across markets and the global economy.
The views expressed herein are presented for informational purposes only and are not intended as a recommendation to invest in any particular asset class or security or as a promise of future performance. The information, opinions, and views contained herein are current only as of the date hereof and are subject to change at any time without prior notice.
Senior Economic Analyst
Boyd Watterson Asset Management, LLC