Fed seeks to find alternative signals to inverted yield curve

According to reporting by Reuters, the US Federal Reserve are on the hunt for new signals from financial markets that are accurate enough to deliver recessionary warnings, over and above the track record of the inverted yield curve.

Key quotes

"In the run up to previous downturns, the Fed has jacked interest rates to restrictive levels as it sought to temper inflation. This time, the central bank hopes for a softer landing with rates moving just high enough to avoid overheating without ending a nearly decade long expansion.

New research from staff economists Eric Engstrom and Steven Sharpe, presented at the Fed’s June meeting, suggests that some of the traditional warning signs of recession, such as the gap in interest rates between 10-year and 2-year Treasuries, may not be as powerful as analysis that focuses on shorter term rates.

In particular, they found that the difference in current interest rates on 3-month Treasury bills and those expected in 18 months served as a stronger predictor of recession in the coming year by capturing the market’s conviction that the Fed would need to cut rates soon in response to a slowdown.

Their measure showed little recession risk on the horizon - a green light for continued gradual increases in interest rates at a time when some Fed officials have taken the narrowing spread of long-term yields as a sign the Fed should halt its rate hikes now.

According to the new research, the "near-term" yield curve captures well formed market expectations about coming economic conditions, but without some of the longer-term concerns that drive other bond yields.

The Atlanta Fed has been looking at the future Fed policy rate implied by eurodollar contracts, a financial security involving dollar deposits in overseas banks that reflects the interest rates investors anticipate in coming months.

“We are doing a lot of work to see what metrics are there to give us signals about weakness in the marketplace...I want to make sure we do all that we can not to miss something,” Atlanta Federal Reserve bank president Raphael Bostic told reporters recently."

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