The bond market is sending the Federal Reserve a warning just as Jerome Powell prepares to take over as chairman.
The current Fed governor, who was nominated this week, is no doubt watching those same perplexing moves in the Treasury market, where the spread between long-end bond yields and short-term yields have dramatically narrowed — resulting in a curve flattening. That move has made the curve the flattest it's been since 2007.
The fact that the curve is compressing just as President Donald Trump nominated Powell to replace Fed chair Janet Yellen has also added fuel to both sides of the debate about whether the Fed can stick to its forecast of three interest rate hikes next year. The Yellen Fed is expected to raise interest rates in December, and the bottom line issue is whether inflation will improve enough for the Fed to continue raising rates.
A flattening yield curve can be the precursor to an inverted curve, where the short end, or in this case 2-year yield, rises above the long end, or the 10-year yield. An inverted curve is the real sign of trouble and historically has signaled recession.
"The yield curve is a pretty useful tool, and it has a pretty good track record," said Joseph LaVorgna, chief economist for the Americas at Natixis. "When the curve is really flat or inverts, historically it's not been a good sign for where you're going to be in the next year. A flat curve today tells you a year from now growth is going to be weaker."