Will the Fed cut interest by a whopping 50 basis points?

There is a chance it will today. If it does, it could lead to a steepening event?

Currently, the US yield curve has been in a state of inversion for a really long period of time, signalling a potential economic downturn. I like to think of this as the weather forecast before a storm. When the storm comes, you often get a yield curve steepening event.

Take a look at this data visualisation. Notice that after yield curve inversions, steepening events often precede recessions (though not every inversion leads to a recession).

Let’s explain what is going on here. When long-term yields rise relative to short-term yields, the curve steepens… well obviously!!

A steepening yield curve typically occurs when long-term growth and inflation expectations rise. However, if the curve steepens while the economy is slowing, it could reflect that the Fed is expecting a future recession.

Now to be honest, there are no secrets here. We see the same data at the Fed. But the signals have been sent (i.e. mini leaks in the Wall Street Journal) that this 50bps cut might be coming.

Historically, the yield curve tends to dis-invert before recessions. The recent brief righting (dis-inversion) of the yield curve after a prolonged inversion is a macroeconomic signal that typically precedes recessions. Watch this happen at the end of the data visualisation. No more yield curve inversion!

The logic is that markets anticipate the Fed lowering short-term rates in response to weak economic conditions. But a 50bps cut is larger than what was expected when this dis-inversion first started occurring, so such a move could initiate a steepening of the curve.

Over the longer term, markets might expect an eventual recession and rate cuts, which would drive long-term yields down, further steepening the curve.

It’s also worth considering that the composition of Treasury ownership has changed significantly over time, with the Federal Reserve now holding a larger proportion compared to previous decades. This shift in ownership dynamics could affect the yield curve’s behaviour, and comparisons to historical data should be made with this in mind. In other words, we may not see a steepening event at all.

What do you think about this?

Music: Comes Back Around by Mindme, Epidemic Sounds