Big Step Hinted by US Powell... 'R Fear' Resurfaces Amid Aggressive Tightening

[Image source=Reuters Yonhap News]

[Asia Economy New York=Special Correspondent Joselgina, Reporter Park Byunghee] Jerome Powell, Chairman of the U.S. Federal Reserve (Fed), which leads global monetary policy, hinted on the 21st (local time) at the possibility of a so-called ‘big step’ of raising interest rates by 0.5 percentage points at once, despite concerns about economic slowdown.

As U.S. Treasury yields rose across the board, the yield spread between the 10-year and 2-year Treasury bonds narrowed to just 0.17 percentage points, increasing warning signs of an inversion between long- and short-term yields. Yield curve inversion is generally considered a precursor to a recession. This suggests that the Fed’s aggressive tightening could lead not just to economic slowdown but to a recession.

◆Powell Signals Big Step: "Inflation is Too High"

At the National Association for Business Economics (NABE) conference that day, Fed Chairman Powell said, "The labor market is very strong, but inflation is too high," and added, "If it is concluded that moving more aggressively is appropriate, we will do so," delivering hawkish remarks. This came less than a week after the Fed raised interest rates at the Federal Open Market Committee (FOMC) meeting for the first time in three years and three months. The market widely regarded his comments as more hawkish than the post-FOMC press conference.

In particular, Powell stated, "We may take firm tightening measures beyond the neutral level," clearly indicating a willingness to accept some economic slowdown to curb inflation. This effectively signals a 0.5 percentage point rate hike along with balance sheet reduction at the upcoming May FOMC. According to the Chicago Mercantile Exchange (CME) FedWatch, the federal funds (FF) futures market on that day priced in nearly a 60% chance of a 0.5 percentage point hike at the May FOMC.

Markets reacted sharply to Powell’s hawkish remarks. The New York stock market fell across the board, and U.S. Treasury yields surged regardless of maturity. The 10-year Treasury yield jumped to 2.30%, the highest since May 2019. The 30-year yield rose to 2.52%, and the 2-year yield exceeded 2.13%.

The 2-year yield, sensitive to monetary policy, has risen by a remarkable 0.69 percentage points just this month as the Fed’s tightening stance became clearer. This is the largest monthly increase since April 2004. Alan McKnight, Chief Investment Officer at Region Bank, conveyed the mood, saying, "There is a lot of anxiety in the bond market about how far the Fed will go and how much the inflation trend will worsen."

◆Narrowing Long-Short Yield Spread... A Sign of Recession?

In particular, the market is paying attention to the rapid narrowing of the long- and short-term yield spread during this process. There are also expectations that the 2-year yield may soon surpass the 10-year yield, causing an inversion. Since 1960, whenever the long- and short-term Treasury yields inverted?except for the cases in 1966 and 1998?a recession occurred within 1 to 2 years.

This year, the yield spread between the 10-year and 2-year bonds has narrowed by more than 0.6 percentage points. According to Tradeweb, the yield spread between the 10-year (1.63%) and 2-year (0.79%) bonds on January 3 was 0.84 percentage points based on closing prices. However, on this day, the spread was only 0.17 percentage points. Generally, a spread below 0.5 percentage points is considered a warning signal. The 10-year and 7-year yields have already inverted, and the 10-year and 5-year yields are close to inversion.

This trend has been observed since October last year, when the Fed officially signaled rate hikes. Short-term yields, sensitive to monetary policy, rose rapidly, while long-term yields rose more slowly, reflecting economic uncertainty, thus narrowing the yield spread. Bank of America (BoA) diagnosed, "The recent narrowing of the 2- to 10-year yield spread reflects recession risk beyond just a response to the Fed’s tightening start."

According to CNBC, the probability of the U.S. entering a recession within the next 12 months is over 30%, and over 50% for Europe. Especially with the Ukraine crisis causing energy prices to surge, concerns about ‘stagflation’?rising inflation amid economic slowdown?are increasing.

Powell also addressed concerns about the narrowing long- and short-term yield spread that day. However, he emphasized that an internal Fed report states that the yield spread over 18 months is a more accurate predictor of recession than the 2- to 10-year yield spread. The spread between the 3-month Treasury yield and the 18-month forward rate in the futures market is widely expanded at 2.29 percentage points.

Fed economists Eric Engstrom and Steven Sharpe argued in a June 2018 report that the short-term Treasury forward rate spread predicts recessions more accurately than the 2- to 10-year Treasury yield spread.

This content was produced with the assistance of AI translation services.