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Powell’s Favored Curve Calls Time on the Fed’s Tightening Cycle

(Bloomberg) -- Bond traders are declaring victory over the Federal Reserve’s war on inflation after it slowed last month to a weaker pace than economist forecasts.

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A part of the yield curve that Federal Reserve Chair Jerome Powell watches closely to monitor recession risks inverted for the first time since the pandemic hit in early 2020. The so-called near-term forward spread -- which tracks the difference between expected yields on three-month Treasury bills in 18 months and those on current T-bills -- fell to minus 14 basis points Thursday.

Powell argued that an inversion in the measure “means the Fed’s going to cut, which means the economy is weak,” when he brought investors’ attention to it earlier this year. It has now joined other parts of the yield curve, such as three-month and 10-year, that have turned upside down, which typically shows expectations that economic growth is poised to halt.

A 2018 Fed research paper first highlighted the importance of this forward curve as a more reliable recession indicator than traditional yield curves.

In this case, however, the inversion was set off by the report showing that inflation cooled in October, not by bad economic news that stoked recession fears. Stocks rose sharply and bond yields tumbled afterward, with investors anticipating that it will give the Fed room to ease up on its aggressive monetary policy tightening.

Traders pared their expectations on how high the Fed will raise rates and Eurodollar futures showed pricing moving back toward two full rate cuts for 2023.

When asked about the forward curve at the Nov. 2 press conference following the Fed meeting, Powell said that while it remains the Fed’s preferred measure, one also needs to understand the reason why the markets are expecting rate cuts.

“You have to look at why things, why the rate curve is doing what it’s doing,” said Powell. “In this case, if you’re in a situation where the markets are pricing in significant declines in inflation, that’s going to affect the forward curve.”

Given that this inversion was driven by a slowdown in price growth, that could indicate traders are becoming too optimistic about the return of easier monetary policy.

“I suspect the market is getting a little ahead of itself in terms of pricing in cuts,” said Andrew Ticehurst, a rates strategist in Sydney for Nomura Inc. “Central banks have still been talking about holding rates at higher levels for longer.”

(Updates throughout)

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