Tightening, Flattening, and Inversions - Global Macro Update - 10/29/2021
Yield curves are sending a warning.
Things are heating up in the rates world. Yield curves all around the world are in flattening mode, sending a strong signal to the market that momentum is shifting in the global economy. I believe understanding the sequence of events leads to a better understanding of Fed actions and the direction of interest rates.
Let’s begin with inflation. The global economy is hot, and demand is robust. This puts a natural upwards pressure on prices. Supply chain constraints have then compounded price pressures, resulting in multi-decade highs in inflation around the world. The inflation however, despite all the central bank monetary stimulus since the pandemic began, is not a monetary phenomenon. A dearth of west coast truck drivers, Chinese zero-tolerance policy toward the virus, and a global chip shortage are not monetary sources of inflation. The Fed and other central banks are forced to respond to inflation by tightening monetary policy regardless, even though higher interest rates are not going to suddenly make truckers appear at the ports of Los Angeles and Long Beach.
Next, the tightening. As 2021 began, central banks were engaged in ultra-loose monetary policy—rates anchored to zero and bond purchase programs turned to maximum. This is now being reversed; the Fed will announce a taper in November, and QE is scheduled to end sometime next year. The market then expects the Fed to begin hiking rates in late 2022. This is being expressed as “policy error” by the yield curve.
The 5s30s curve (30-year US Treasury yield minus 5-year yield) has flattened aggressively over the past six months. This is called the “policy error” trade—5-year yields increase as they respond more directly to monetary policy, while 30-year yields decrease as long-term growth expectations come down. The market is suggesting that the Fed tightening will slow down the economy and eventually cause a policy reversal, in which rate hikes become rate cuts again. Right now, the market is potentially placing that date of policy reversal in 2024. Just a few months ago, the hiking cycle was expected to continue into 2026. Yield curve inversions ALWAYS precede rate cuts. Watch the flattenings closely.
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