Yield curve inversion steepens

• Markets are becoming increasingly bound together, elevating risk.
• With investors so transfixed on the Fed’s rate policy and the challenges in the near-term investment cycle, capital markets are tightening.
• Money supply is reversing course despite a buoyant service sector, giving the market pause for thought on the Fed’s rate hike plans.

Brakes are still being applied

Attempting to turn the course on a bloated post-pandemic economy is challenging for policymakers. Despite applying full-power reverse on the money supply, with tanks laden with pandemic emergency funding, the turning circle is wide.

The severe monetary policy measures being taken have inverted the yield curve further to -0.81 %. A negative yield curve is problematic for several reasons. It implies flights of capital to later maturities, leaving less business momentum on the ground when the Fed commences easing measures.

Furthermore, an inverted yield curve will also cause losses on the rolling of maturities held by large pension funds and money managers, taking a toll on retirement savings, just as they’re being decimated by inflation.

Raising rates: 10-year vs 2-year, firmly in negative territory

Often used as a recessionary indicator, the 10-year yield versus the 2-year differential is negative, an inverted yield curve caused by sharp rises in lending and saving benchmark rates.

Impact on money supply

The costly yield curve inversion is an unfortunate side-effect of the Fed’s desired deflationary outcome of stemming the amount of money. The Fed’s adjustments are starting to have an effect, but the progress is slow. The convex trajectory is reflective of the enormity of the task at hand.

Market interpretations

The stock market rebounded sharply on Thursday last week. The consensus interpretation of Fed Chairman Jerome Powell’s policy speech was that with the money supply capping out, slower rate hikes were the order of the day.

To Monday this week and a strong reading in the US services sector. Indicative of stubborn inflation as the derivative effects will take many months to stabilise, the market has swung the needle back to the likelihood of sharper rate hikes due to persistent inflation.

Services comprise the most significant proportion of the US and Australian economies. If labour costs continue to rise, cost increases will be passed on to consumers, creating a negative feedback loop on inflation-adjusted wages.

Despite energy costs declining, a constant level of high employment and wage inflation may force the hand of the US Fed to revert to sharper rate hikes to press down on the money supply and, by extension, inflation.

Summary

The highly irregular nature of the depth of inversion in the US Treasury yield curve, upon which the world values most of its assets, reflects the lengths the Fed has had to go to slow the economy.

Money supply has retreated, but from a high starting point, and progress has been slower than perhaps policymakers might have wished for at the outset.

The market consensus view reflected in the moderate sell-off on Monday suggests an awareness that all is not well, and perhaps we need to shed a little more weight in case the course becomes treacherous.