On Friday, Federal Reserve Chair Jerome Powell finally told the market what it wanted to hear.
A September rate cut is coming.
Every year since 1982, top bankers gather at Jackson Hole, Wyoming. They discuss economic issues and the outlook on things like interest rates.
In recent years, Powell has used the venue to communicate changes in monetary policy.This year is no different.
Powell has set the table for a rate-cutting cycle, stating, “The time has come for policy to adjust.”
But as the Fed prepares to cut rates as soon as next month, there’s a cause for concern as well.
Its actions could trigger a recession signal…
Watch the Yield Curve
The Fed controls short-term interest rates with the Fed funds rate.
After inflation soared in 2021, the Fed began raising interest rates to the highest level in over 20 years.
That pushed short-term interest rates above longer ones, which “inverted” the yield curve.
Normally, longer-term rates are higher than shorter-term ones. After all, people who buy bonds, for example, need more compensation in exchange for locking up their money for a longer period.
So it’s worth noting when that relationship flips on its head.
The line in the chart below is the 10-year Treasury yield minus the 2-year Treasury yield for the past 10 years.
When the blue line is below zero (the black line), that means the 2-year yield is higher than the 10-year… and the yield curve is inverted.
Historically, that has been a good recession signal because it means the Fed has pushed interest rates too high.
But economists have been left scratching their heads this time around.
The yield curve has been inverted since July 2022, but there hasn’t been a recession.
That’s because inversion itself isn’t the signal that should concern you.
In the past, it’s when the yield curve uninverts that the recession countdown starts.
And that’s why Powell’s Jackson Hole speech is cause for concern.
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The Real Recession Signal
The 2-year Treasury yield tends to turn higher or lower before the Fed funds rate changes. Bond investors try to guess where short-term rates are heading ahead of the Fed taking action.
And lately, the 2-year yield is plunging. Since the end of April, it has gone from 5.05% to 3.93%.
That’s a sign the market expects the Fed to start cutting quickly. And Powell’s comments at Jackson Hole confirm it.
But the Fed usually only reduces rates at a quick pace when clear signs emerge that the economy is stalling.
By then, the Fed is usually too late.
Even Powell said during his remarks that “cooling in labor market conditions is unmistakable.”
So a falling 2-year yield may mean the yield curve is about to uninvert.
Here’s the difference between the 10- and 2-year yield going back 40 years. The shaded areas represent recessions.
The blue line has moved back above zero just before each of the last four recessions.
So when it comes to timing a recession, it isn’t the inverted yield curve you should worry about.
It’s when it uninverts.
It did so briefly on August 5 when stock markets were in free fall around the world. And it’s close today.
So as interest rate markets digest Powell’s speech at Jackson Hole, the next recession signal could be just around the corner.
Regards,
Larry Benedict
Editor, Trading With Larry Benedict