Sandrine Soubeyran
Robin Marshall
Lower US inflation has reinforced expectations that the US Fed’s tightening is nearly done, prompting 10-year Treasuries to rally further in January, and extending the bull inversion of the US 10s/2s curve. Chart 1 shows how 7-10-year US Treasury yields have fallen faster than 1-3-year yields, which have remained anchored by a further 75bp of Fed tightening at the December and February FOMC meetings.
Chart 1: Longer-dated bonds rallied ahead of shorts as they did in 2005-07 - US 7-10yr Treasury vs 1-3yr yields in last 20yrs
Source: FTSE Russell, 20 years data to February 8, 2023. Past performance is no guarantee of future results. Please see the end for important disclosures.
Another Greenspan conundrum in 2022-2023?
Chart 1 also shows that bull inversions of the 10s/2s yield curve, where long yields initially fall faster than short yields, are typical of cyclical turning points in Fed monetary policy. In 2004-07 – in the so-called Greenspan “conundrum” of longer-dated yields stabilising and falling as the Fed tightened – the 10s/2s yield curve inverted completely in advance of the global financial crisis (GFC). There are also some intriguing parallels between the 2004-07 period with 2022-23. In 2004-2007, energy prices rose sharply, and the labour market continued to tighten, with unemployment falling from around 6.0% to 4.0% ─ a similar decline to the fall from 6% in 2021 to 3.4% in January 2023, a 53-year low (Chart 2).
Chart 2: Tight labour market the wild card for Fed policy? - US unemployment and wage growth (%)
Source: FTSE Russell, 20 years data to February 8, 2023. Past performance is no guarantee of future results. Please see the end for important legal disclosure.
The pace of Fed tightening has been much faster in 2022-2023
As the labour market continued to strengthen and US economic activity expanded at a strong rate, the Greenspan Fed removed its policy accommodation in 2005-07, and increased the target range for the Federal funds rate gradually via 17 increments of 25bp, over two years. This 4.25% of tightening, is a very similar magnitude of tightening to the 4.50% by which the Fed has raised interest rates so far in 2022/23, and from a similar starting point on Fed funds, but within a much shorter period of 11 months, more than twice as fast as the 2005-07 tightening cycle. Indeed, Chart 3 shows the tempo of Fed tightening in 2022/23 has far exceeded that of previous cycles this century.
Chart 3: Steeper Fed rate rises in 2022/23 vs gradual moves during 2004-2007 - US Federal Funds rates - 20 years (%)
Source: Refinitiv Datastream, data as of February 2023. Past performance is no guarantee of future results. Please see the end for important legal disclosure.
Higher for longer US wage inflation is the obvious tail risk to the soft-landing scenario…
This raises the question on whether the central case of a soft landing (versus a deeper recession), apparently discounted by markets, can be achieved. One obvious, high-profile, tail risk stems from the tightening of the US labour market, after unemployment fell to a 53-year low in January (3.4%), as Chart 2 shows. The Fed could find itself forced to tighten more aggressively than predicted, should wage inflation remain sticky, leaving a higher terminal rate for Fed Funds, than the 5.1-5.4% currently projected from the December dot plots.
…but the 2005-07 episode suggests over-tightening risks should not be discounted
This risk to the soft-landing scenario has a higher profile after the recent surge in January payrolls, but the labour market is a lagging indicator, and there is another tail risk that the 2005-07 tightening episode reveals, which has been largely ignored to date. This is because the Fed overdoes the monetary tightening, by focussing on lagging indicators like the labour market and inflation, and a deeper recession ensues in 2023/24, as it did in 2008-09. Persistent inversion of the 10s/2s yield curve and its strong forecasting record in predicting US recessions means that this risk cannot be discounted.
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