The Treasury yield curve has been dropping as bond traders speculate that the Fed will start to cut the fed funds rate as early as the middle of next year, caving in as the economy slows even if inflation stays high. They also believe that inflation will subside and a recession is in the cards, shown by a negative yield spread between the 10-Year Treasury Constant Maturity Minus 2-Year Treasury Constant Maturity.
The Wall Street Journal has had several articles about this. Guess what? The Fed reads the WSJ and watches the bond market!
**Fed’s Kashkari says officials are ‘a long way’ from backing off inflation fight.**
**Neel Kashkari, the president of the Federal Reserve Bank of Minneapolis, said the Fed had more work to do in trying to control price increases.**
**By Jeanna Smialek, The New York Times, July 29, 2022**
**Neel Kashkari, the president of the Federal Reserve Bank of Minneapolis, suggested on Friday that markets had gotten ahead of themselves in anticipating that the central bank — which has been raising interest rates swiftly this year — would soon begin to back off.**
**“I’m surprised by markets’ interpretation,” Mr. Kashkari said in an interview. “The committee is united in our determination to get inflation back down to 2 percent, and I think we’re going to continue to do what we need to do until we are convinced that inflation is well on its way back down to 2 percent — and we are a long way away from that.”**
**“I don’t know what the bond market is looking at in reaching that conclusion,” Mr. Kashkari said, adding that the bar would be “very, very high” to lower rates....** [end quote]
The bond market is looking at late 2018, when Powell’s Fed backed off of raising rates when the market had a hissy fit. (Inflation was not high at that point.) The bond market is looking at the 1970s, when the Fed backed off of raising rates when the economy slowed even though inflation was still high, enabling even higher inflation.
If Powell and Kashkari are serious, the Fed will continue to raise the fed funds rate (and maybe also speed the roll-off of their huge book of longer-dated bonds). The yield curve will either rise or become inverted (which usually predicts a recession).
If the bar will be very, very high to lower rates the markets will be surprised. That implies a much longer pathway through and out of a recession.
Bond and stock prices are not reflecting this. That implies a negative shock to both markets.