By Karen Brettell
(Reuters) - The Federal Reserve’s stunning about-face on rate increases along with weak economic data has left a key part of the U.S. Treasury yield curve close to levels at which the U.S. central bank has in the past been prompted to cut rates.
The Fed on Wednesday brought its three-year drive to tighten monetary policy to an abrupt end, abandoning projections for any interest rate hikes this year amid signs of an economic slowdown, and saying it would halt the steady decline of its balance sheet in September.
Rather than boost investor confidence, however, "the Fed’s ongoing actions and messaging have left markets more pessimistic than ever about the U.S. economic outlook," said Win Thin, global head of currency strategy at Brown Brothers Harriman in New York.
The yield curve between two-year and five-year notes inverted further than it had been and is now approaching levels at which the Fed has in the past cut rates.
The spread between U.S. three-month bills and 10-year notes yields on Friday also turned negative for the first time in over a decade, triggering a warning that if the inversion persists a recession may follow in the next one-to-two years.
Graphic: Yield Curve - https://tmsnrt.rs/2UQ8hrq
Inversions between two-year and five-year note yields beyond 12 basis points have previously been met with easing, said Tom Fitzpatrick, chief technical strategist at Citigroup (NYSE:C) in New York. It is currently 6 basis points after reaching 9 basis points on Friday.
An exception was in 2006, when the Fed waited 10 months after an inversion of 19 basis points to cut rates. That was followed by the financial crisis of 2007-2009, which resulted in zero interest rates and years of quantitative easing.
In the past the inversions and subsequent rate decreases have occurred against a backdrop of very adverse events, including the savings and loans crisis in 1989, the implosion of the Nasdaq stock index in 2000 and the U.S. housing decline in 2006.
There is no obvious comparable today though trade tensions with China and Britain’s exit from the European Union are among risks that threaten the U.S. economy.
If there is an inversion past 12 basis points, “my gut would be it’s not happening for absolutely no reason, it’s happening because there’s some level of nervousness and there are events out there that could cause it,” said Fitzpatrick.
A worsening employment picture could also prompt the Fed to act. A rise in unemployment claims has preceded curve inversions and rate cut moves in the past, Fitzpatrick added.
Graphic: Initial Claims - https://tmsnrt.rs/2OjK1vz
If long-dated Treasury yields continue to decline the Fed may cut rates as a proactive move to stave off recession. This has been effective before. Rate cuts in 1995 and 1996 helped to push out a recession until 2001.
The Fed has cut rates prior to the last three recessions, after adopting a funds rate targeting policy in 1982, Morgan Stanley (NYSE:MS) strategist Matthew Hornbach said in a report on Monday.
In these cases, the Fed cut rates on average about eight months after the three-month, 10-year yield curve first inverted, which in this case would imply a December cut, Hornbach said.
"While our economists believe that the Fed's next move will be a 25bp hike in December, not a cut, we see room for markets to put a higher probability on a rate cut in 2019 if economic data struggle over the coming months," he said.
John Herrmann, a rates strategist at MUFG Securities Americas in New York, believes a cut will be needed by September, saying that the Fed needs to negate its hike from December, which he calls a “mistake” given a weakening economic outlook.
“The persistent weakness in global growth coupled with deceleration in growth in the U.S. ... suggests really removing that last unjustified rate hike in the near term, and then beginning to fine tune policy to where the economy really is, not to where they hoped it would be,” Herrmann said.
Interest rate futures traders are currently pricing for an approximately 60 percent chance of a rate cut by December, according to the CME Group's FedWatch tool.