A market indicator watched by the Fed as one of the most accurate gauges of economic health is pricing in lower rates for the first time in more than a decade.
The little-known near-term forward spread, which reflects the difference between the forward rate implied by Treasury bills six quarters from now and the current three-month yield, fell to -0.0653 basis point on Wednesday.
It was the first time since March 2008 the gauge — seen as a proxy for traders’ outlook on Federal Reserve policy — fell below zero.
Crossing the threshold indicates the market sees easier policy and recession in “the next several quarters,” economists at the U.S. central bank wrote in a research paper dated July 2018.
“When negative, it indicates market participants expect monetary policy to ease, presumably because they expect monetary policymakers to respond to the threat or onset of a recession,” Eric C. Engstrom and Steven A. Sharpe wrote. “When market participants expected — and priced in — a monetary policy easing over the next 18 months, their fears were validated more often than not.”
Money markets have been paring back expectations of rate hikes as economic data weaken and equities whipsaw. Last week, traders priced in no move in the Federal Funds rate this year and more than a 50% chance of a rate cut in 2020.
In their paper, the Fed economists said the gauge had more predictive power than other long-term spreads, such as the differential between two- and 10-year Treasury bonds.
Still, some investors including Manoj Hemrajani, manager of the Macroscope hedge fund, prefer to take their cues from the latter. Hemrajani said he anticipates it will turn negative in 2019.
“That’s a more visible spread to investors,” he said. “And it’s not one an investor needs to compute, unlike the one the Fed paper mentions.”
