On Wednesday, February 1, the FOMC will conclude its two-day meeting and in all likelihood announce a 25 basis-point increase which will take the Fed Funds Target range to 4.50% – 4.75%.  While we’re interested to hear Powell’s remarks, we expect they will be much of the same narrative that inflation is cooling off but still remains too high; the economy is showing signs of slowing but remains strong and the labor market is very tight.  All said, the FOMC will reiterate its commitment to fight inflation “until the job is done” of returning price stability to the people.

Here’s the interesting thing – if, in fact, Powell does stay within the above narrative he’ll be contradicting what he said in March of 2022 during a speech at a conference hosted by the National Association of Business Economics.  Little did Powell know, at that time, he was painting himself into a corner. 

To set the stage, Chairman Powell was at the end of an hour fielding questions when the moderator circled back to the shape of the yield curve because it had flattened out considerably and was approaching inversion.  (We have written previously, here and here, about fixed income markets and yield curve inversion for those who would like a reprise.)

Chairman Jerome Powell’s answer:

“Frankly, there’s good research by staff in the Federal Reserve system that really says to look at the short — the first 18 months — of the yield curve.  That’s really what has 100% of the explanatory power of the yield curve. It makes sense. Because if it’s inverted, that means the Fed’s going to cut, which means the economy is weak.” (our emphasis added).

Specifically, Powell was referencing what is called the near-term forward spread.  What is that?  Here is Anthony Diercks and Daniel Soques of neartermforwardspread.com, “The near-term forward spread is the difference between the expected 3-month interest rate 18-months from now minus the current 3-month yield.”  This is the specific part of the yield curve Jerome Powell was speaking about back in March of 2022 and he was doing so at a time when the spread was 2.32%.

While we would pushback on the statement that the first 18 months of the yield curve has 100% explanatory power (the long-end of the curve has plenty of power in our view; it’s just often dismissed or misinterpreted) we wholeheartedly agree with the Chairman that when it is inverted, the Fed will be forced to cut.

Ok, so, what is the near-term forward spread as we speak?  Is it inverted?  Yes, it is.  The latest data from Diercks and Soques was on January 20th showing -0.98%.  In technical terms, we call that level of inversion, “a lot”.

Will reporters ask Powell on Wednesday afternoon to update how this impacts the FOMC’s views of the economy, monetary policy and recession?  We hope so.  But even if not, or if Powell is asked and deflects with a non-answer, answer, the important takeaway isn’t necessarily when and by how much the Fed may be forced to cut – it’s the WHY would they have to cut that needs to be answered. 

And to that, our answer would be leading economic indicators including fixed income markets are clearly signaling the Fed will have to turn their attention toward recessionary pressures in 2023 and away from the dogmatic mantra of – inflation.

We’ll end by reiterating what we wrote in our latest newsletter that our plan of action heading into 2023 is to continue to think in risk-adjusted terms, position portfolios with an eye towards preservation, capitalize on the yield environment and maintain prudent equity exposure. 

To our clients, as always, please contact us with anything on your mind.  To our other readers, if you’d like to hear more about our approach to investment management and planning, we welcome the opportunity to hear from you.