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Investment Ideas Flattening of U.S. yield curve faces risk from Fed’s trade concern

The relentless flattening of the U.S. yield curve could be poised for a breather, as investors look for signs this week that escalating trade disputes will alter the Federal Reserve’s plans to lift borrowing costs.

Thursday’s release of minutes from the central bank’s June meeting looms large in a holiday-shortened week, after two Fed presidents warned that trade friction is weighing on businesses and clouding the economic outlook. The next day brings a U.S. deadline to slap $34-billion in tariffs on China, a threat that Beijing has already pledged to retaliate against.

The 10-year Treasury yield fell the past three weeks, shrinking its spread over two-year debt to the narrowest since 2007. Any hint that the Fed may pull back from plans to hike twice more this year – as officials signalled in June – could slow the curve’s march toward inversion. Barring that, the latest monthly job-market reading at the end of week stands to hammer home that the economy is solid enough to warrant tighter policy.

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“The minutes will be important because we’ll get a further idea about what kind of caution is shaping into the Fed’s thinking regarding the effects of the trade war,” said Ben Emons, chief economist and head of credit portfolio management at Intellectus Partners. “There is a group that already wants to pause hiking. If the market senses a bigger campaign for that, then traders will lower the probability for a third or fourth hike and that should at least moderate the curve flattening.”

The 10-year note yields 2.86 per cent, down from the 2018 high of 3.13 per cent set in May. The two- to 10-year yield spread is about 33 basis points, with the gap between five years and 30 years at about 25 basis points, also close to the smallest since 2007. The shape of the curve is drawing scrutiny because inversion has been a reliable indicator of recessions.

The curve’s contraction gained momentum last month as policy makers lifted rates and raised their projections to a total of four increases for the year. The Fed’s preferred inflation gauge has been at or above its 2-per-cent inflation goal for three straight months, backing the case for more aggressive tightening.

Still, the economic hit from tit-for-tat tariffs creates risk.

“Changes in trade policy could cause us to have to question the outlook,” Fed Chairman Jerome Powell said at a European Central Bank conference on June 20. Last week, St. Louis Fed President James Bullard said he’s hearing “full-throated angst” from companies. And the Atlanta Fed’s Raphael Bostic said businesses are “extremely concerned about the prospects of a trade war.’’

For now, traders are pricing in another rate hike in 2018, with some chance of a fourth.

Strategists are also looking to the minutes for insight into the Fed’s June tweak to the interest rate on excess reserves, or IOER. Last month, officials lifted it by less than they hiked their policy rate, amid a drift in the funds rate to the higher end of their target range. One key question is hanging for investors: whether that move is a one-off adjustment.

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“We expect that the Fed will need to elaborate on their decision to lower IOER in the target range and hope that the Fed will finally start to signal their preferred end state for the Fed’s balance sheet,” Mark Cabana, a Bank of America Corp. rates strategist, wrote in a note.

However the Fed minutes unfold, the world’s biggest debt market may be set for volatility during a week when many traders are braced for the start of the summer doldrums. If it doesn’t come from President Donald Trump’s next big decision on trade, there are always the jobs data.

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