Summary:

• Non-Voting Fed member issues market warning
• “I think you have to respect the signalling… of the yield curve”
• US 10-year yield hits 2 week low

There’s been some noteworthy comments from James Bullard on CNBC today, with the non-voting member of the Fed essentially saying that investors and traders shouldn’t ignore what the yield curve is saying. Bullard said that changes in the bond market are the main focus point for investors at the moment, and that they should specifically looking at the gradient and be wary of a possible inversion in the not too distant future. An inversion of the yield curve has previously pre-empted economic recessions and is currently not too far from displaying this phenomenon.

 The US 10-year yield has been falling in recent sessions, as shown by the TNOTE which looks set to post its 3rd consecutive day of gains. Price could be set to test the prior breakout level around 119.95. Source: xStation

“I think the state of affairs is good for today, the question is how to play things going forward over the next two years. If the Fed raises rates 50 basis points and the 10-year (Treasury bond) does not cooperate, you could see an inverted yield curve in the U.S.,” Bullard told CBNC’s “Squawk Box Europe” Monday.

 Given the previous strong correlation between the TNOTE and USDIDX, any further gains for the TNOTE could start to cap the upside for the USD. Note USDIDX axis is inverted. Source: xStation

The reason why an inverted yield curve is in keeping with a forthcoming recession is what it tells us intuitively from an economic standpoint. Short term rates are typically sensitive to monetary policy, while further out along the curve (10-year plus) is seen as more of a reflection of the long-term prospects for the economy. If the Fed continue to hike rates, then there’s a good chance that near term yields will continue to rise, but unless future economic prospects are deemed to also increase, then the further dated bonds won’t move – and this can lead to an inversion. When the economy is performing well (EG 2006) then it is common for the Fed to hike rates, and there becomes a point when future expectations for the economy are so high (as they arguably are at present) that there’s a high bar for them to be raised further. 

 TNOTE and Gold have also exhibited a correlation previously and the recent gains in the former could be seen to support the latter. Note that the drop in the Tnote which began in April led Gold lower in the months that followed (and the USD higher). Source: xStation