While yield-curve inversion ‘concerning,’ Fed won’t cut

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The temporary inversion of parts of the yield curve “are concerning,” but since they’re based on coronavirus fears, the economy should keep growing and will not necessitate cuts to the fed funds rate target, analysts say.

“Recent yield-curve flattening and the brief inversion are concerning,” said Brian Rehling, Wells Fargo Investment Institute co-head of global fixed income strategy. “Yet, at this time, it does not alter our slow-but-positive 2020 U.S. economic growth expectations. Bond market yield-curve trends continue to suggest that the economy is susceptible to geopolitical shocks — but thanks to a strong U.S. consumer, we expect U.S. economic growth to remain resilient in 2020.”

Brian Rehling, Wells Fargo Investment Institute co-head of global fixed income strategy

And things should improve. “Incoming information supports the view that we are in the process of coming out of a mid-cycle slowdown,” said Nick Reece, senior analyst and portfolio manager at Merk Investments LLC.

Rehling said the coronavirus fears will fade in “several months but if concerns deepen or other events occur that dampen consumer and business confidence, last summer’s yield-curve inversion signal may yet prove to be accurate.” He warned, “It is too early to call the ‘all clear.’”

The three 2019 rate cuts by the Federal Reserve and the increase in its balance sheet size help “mitigate yield-curve inversion concerns.” These actions, he said, “helped to propel equity markets and encourage risk-taking. It also was likely a factor in the yield-curve steepening in last year’s fourth quarter. While we believe these actions have helped to prolong the recovery, we do not anticipate any new Fed actions in the near term. Further, the Fed’s fourth-quarter easing leaves the Fed with less dry powder to respond to future events.”

KBW’s Fred Cannon notes, “A Chinese equity market sell-off due to the coronavirus would put significant upward pressure on credit spreads and downward pressure on the yield curve and financial stocks. Capital markets and large banks are most at risk.”

Despite the risks from the illness, the probability of a recession in the next half year is low, Merk’s Reece said. “Economic data has continued to improve,” as has consumer sentiment.

However, Reece would like to see the leading economic index “start to trend higher again, and for U.S. and international yields to continue moving higher relative to their 2019 lows.”

The coronavirus will have “a near-term negative impact on the global economy,” he said. “Historically, events like SARS, Ebola, and Fukushima tend to have a negative economic impact but are not dominant factors behind business cycles.”

In the short-term, the U.S. business cycle “is more positive than negative,” with the odds in favor of continued expansion during the next “several months,” he said. “The longer-term outlook remains neutral/negative as we are likely in the later part of this cycle.”

Separately, Federal Reserve Board Chairman Jerome Powell testified before the Senate Banking, Housing, and Urban Affairs Committee, offering no new views. He did note that in case of a downturn, the Fed would use forward guidance and large-scale asset purchases “aggressively” to spur economic growth.

On Monday, the National Federation of Independent Business reported its January Small Business Optimism Index climbed to 104.3 from 102.7 in December, as six components of the index rose.

“2020 is off to an explosive start for the small business economy, with owners expecting increased sales, earnings, and higher wages for employees,” said NFIB Chief Economist William Dunkelberg. “Small businesses continue to build on the solid foundation of supportive federal tax policies and a deregulatory environment that allows owners to put an increased focus on operating and growing their businesses.”

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Economy Monetary policy Federal Reserve FOMC