Fed may encounter some policy mistakes leading the US economy into recession in coming years. Will USD/JPY test 105 again?
Federal Reserve Bank of St. Louis President James Bullard said he doesn’t support more interest-rate increases unless there are upside surprises, in part because the yield curve may become inverted.
- We think the "upside surprises" he mentioned refers to inflation.
- There is a risk that if the Fed continues to raise rates and long-term bond yield do not to follow. Inverted yield curve could be seen within 2018, which is a signal of recession.
- US 2/10 govt. bonds yield spread is at 43 bps, vs 105 bps this time last year.
- Implied forwards are already pricing in for curves to be heading towards zero in 2019, on expectations of additional 2-3 rounds of Fed interest-rate hikes and balance-sheet unwinding.
- The Fed hiking with flat yield curves has preceded the last two recessions. It took two-four years between flat forward curves and a recession.
- Perhaps the Fed slowing or pausing its hikes as forward curves price for flat yield curves could delay or prevent a recession, but such strategies have never been implied before.
Fullerton Markets Research Team
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