(Bloomberg Opinion) -- Message received loud and clear. Federal Reserve Chair Jerome Powell had his foghorn out on Tuesday blaring that there is nothing, repeat nothing, to stop policymakers from yanking interest rates up in half-point steps. His hawkishness prompted the yield curve to flatten to levels not seen since 2016, setting off alarm bells about a potential inversion - where shorter-dated levels rise above longer-term rates - signaling recession.
But looking at the wider picture of the predictive power of yield curves, it is really only when they invert significantly and for several quarters that the recessionary warning holds up. A brief flirtation can often be a false signal. And while economists surveyed by Bloomberg see a greater risk of the U.S. economy suffering two quarters of shrinkage in the coming year, the chances of recession are still only at 20%.
Whisper who dares, but this time is also different. With a Fed balance sheet of $9 trillion after more than a decade of quantitative easing, there are more tools at the central bank’s disposal than just hiking the Fed funds rate. By owning so much of the bond market, it can steer longer-dated yields by choosing which maturities to buy and sell as it unwinds its bond-buying program.
Powell instructed us that his preferred way of looking at the Treasury yield curve is not focused on the two-year to 10-year spread, which is rapidly moving toward zero. Instead, he favors the shorter end of the money-market curve, where there’s still a 180 basis-point differential to longer yields. The size of that gap suggests recession may not be imminent, and explains why Powell stressed the tightness of the labor market as explaining why he is prioritizing the need to curb inflation over the risks to growth.
Combining active balance sheet reduction with rate hikes does increase the danger of a bond-market upset, as happened early in Powell's tenure. But the Fed does need to prepare the ground for stimulus reduction.
The markets are clearly listening to the Fed's forward guidance on interest rates, and have unwound the decline in yields triggered by the flight to quality following Russia's invasion of Ukraine. Including this month’s quarter-point increase, there are 200 basis points of rate hikes now priced in for this year, which would be the biggest 12-month tightening of monetary conditions since the 250 basis-point upward move in 1994. There is every chance traders will also pay attention to what the Fed has to say about quantitative tightening too.
The Fed finally stopped adding to its QE pile this month. It may start scaling back its balance sheet as early as its next meeting in May, although combining that with the 50 basis-point rate increase Powell has threatened to unfurl might be too aggressive. Nevertheless, while the "flow" of bond buying may have stopped, the "stock" effect of such a large balance sheet will provide economic stimulus for many years to come.
The so-called "taper tantrum" of 2013 taught the Fed a salutary lesson about the dangers of surprising bondholders by withdrawing support too rapidly. But the authorities won’t and shouldn’t hesitate to influence longer-dated yields if and when needed. That needn’t precipitate a market rout; merely reminding traders and investors that the central bank has bonds available to sell would do a lot of work in putting some steepness back into the overall shape of the yield curve.
This would be the very definition of the "nimble" approach Powell has emphasized several times that he intends to pursue. In the wake of the global financial crisis, the Fed chair’s predecessors created a range of unconventional monetary tools; he can now use them to herd bond yields as he sees fit.
More From Bloomberg Opinion:
- Fed Being Pushed Into Developing-Economy Camp: Mohamed El-Erian
- Fed Predictability and Sloth Have Their Costs: Richard Cookson
- Now That Powell’s Convinced Markets He Means It: John Authers
This column does not necessarily reflect the opinion of the editorial board or Bloomberg LP and its owners.
Marcus Ashworth is a Bloomberg Opinion columnist covering European markets. He spent three decades in the banking industry, most recently as chief markets strategist at Haitong Securities in London.
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