The yield curve of US government bonds has inverted again this morning in European trading. It is an indicator of future economic developments which is particularly closely watched by the US Federal Reserve. The US bond with a maturity of three months had a higher yield than the US government bond with a ten-year maturity.
Normally, due to the significantly longer maturity, the yield of the ten-year US government bond is higher than that of the US bond, which has a maturity of only three months. However, if the yield curve inverts, market participants obviously assume that the US Federal Reserve will continue to cut interest rates in the foreseeable future. They assume that the economic situation is deteriorating.
For the banks, on the other hand, such an inversion of the yield curve is a major problem. They take up short-term liquidity on the money market in order to lend this liquidity to borrowers in the longer term. If the yield curve is inverted, it is no longer possible to obtain a margin from these loans by means of so-called “maturity transformation”. In the last few days, therefore, share prices of US banks have come under considerable pressure. The US bank ETF (BKX) has broken out of its upward trend channel to the bottom. When banks have no or low margins, they restrict lending. This in turn makes a recession more likely in the US economy, which is so dependent on credit-financed consumption.
The Fed had previously attempted to steepen the yield curve by purchasing short-term US government bonds (Treasury Bills). With some success in the meantime (which is why US bank share prices rose significantly a few weeks ago). Now, however, these interventions to steepen the yield curve have obviously evaporated completely! After yesterday already inverting the 2-year and 5-year yield curves, the inversion of the relationship between the 3-month and 10-year US bond. That is considered the benchmark for recession prediction. It is a warning sign for the economy that is highly regarded by Wall Street.
“QE” – Quantitative Easing
The latest developments put the Federal Reserve in a catch-22 situation. It was very keen to use the term “quantitative easing” to describe its purchases of short-dated US government bonds as objectively unjustified. But now, in order to steepen the yield curve again, it may have to buy longer-dated US government bonds. That is then by definition called “QE” (quantitative easing).
Either way, concerns about the economic impact of coronavirus are taken very seriously by the bond markets. The huge bond market is thus signaling to the Fed that its measures have evaporated. This means that the Fed will have to cut interest rates further. For this reason, the Fed Fund Futures are pricing in a 12.7% probability of a rate cut at this week’s central bank meeting. For September 2020, the Fed Fund Futures are already pricing in a 50% probability of a rate cut.