Yields on two-year and three-year Treasury notes remain higher than five-year yields after both spreads turned negative last week, known as an inverting of the yield curve. However, as we discussed last week, it’s the spread between yields on longer dated Treasuries, such as the 10-year note and the two-year note, which historically has been accurate in predicting recessions. That gap remains positive, and we still see reasons to remain optimistic on the U.S. economy into 2019.
Last week’s inversion at the short end of the yield curve is best interpreted as a signal to the Federal Reserve (Fed) that a 3% target fed funds rate (three more 0.25% hikes) is the upper bound in the current tightening cycle, not as an indicator of a looming recession. Fed Chair Jerome Powell acknowledged this dynamic in a recent speech in which he was notably more dovish than prior comments suggested. “Though economic growth in the United States continues to lead developed nations, moderating growth in wages and consumer prices have dampened the market’s inflation expectations, and the Fed’s balance sheet reduction program and increased government spending are also helping to alleviate some of the pressure to explicitly raise interest rates,” said LPL Chief Investment Strategist John Lynch.
As shown in the LPL Chart of the Day, as the market adjusted its expectations, performance across fixed income sectors changed significantly month over month, reiterating the need for investors to stick to their game plan.
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