The yield curve suggests Fed action may lead to a recession

The Fed has a credibility problem. It regarded inflation as temporary and allowed it to extend beyond the central bank's target. It is now desperate to reign it in. Friday's job report showed that the US labour market is robust, which may help the Fed with its onslaught against inflation.

The unemployment rate fell to 3.6% from 3.7%, and 431,000 jobs were created. This strength gives the Fed room to move with a 50bps hike in May and possibly another 50bps in June. However, we note that the 10Yr-2Yr Treasury yield curve has inverted:

Given the strong labour market, the Fed firmly has inflation in its crosshairs. I.e., the Fed doesn't want to let the expectations of future inflation get out of control. We note that monetary policy focuses on controlling inflation from the demand side of the economy. It can't deal with supply-side or cost-push inflation.

Given that a generous amount of the inflation dynamic is due to supply, the Fed seems to be willing to risk recession to control inflation. It may be calculating that the labour market is resilient enough to ensure a mildness, if it comes to recession. This expectation may be a gamble, and we hope that the central bank is not underestimating the recessionary risk.

Russell Shor

Senior Market Specialist

Russell Shor joined FXCM in October 2017 as a Senior Market Specialist. He is a certified FMVA® and has an Honours Degree in Economics from the University of South Africa. Russell is a full member of the Society of Technical Analysts in the United Kingdom. With over 20 years of financial markets experience, his analysis is of a high standard and quality.

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