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The bond market is sending the Federal Reserve a warning just as Jerome Powell prepares to take over as chairman.


The current Fed governor, who was nominated this week, is no doubt watching those same perplexing moves in the Treasury market, where the spread between long-end bond yields and short-term yields have dramatically narrowed — resulting in a curve flattening. That move has made the curve the flattest it's been since 2007.


The fact that the curve is compressing just as President Donald Trump nominated Powell to replace Fed chair Janet Yellen has also added fuel to both sides of the debate about whether the Fed can stick to its forecast of three interest rate hikes next year. The Yellen Fed is expected to raise interest rates in December, and the bottom line issue is whether inflation will improve enough for the Fed to continue raising rates.


A flattening yield curve can be the precursor to an inverted curve, where the short end, or in this case 2-year yield, rises above the long end, or the 10-year yield. An inverted curve is the real sign of trouble and historically has signaled recession.


"The yield curve is a pretty useful tool, and it has a pretty good track record," said Joseph LaVorgna, chief economist for the Americas at Natixis. "When the curve is really flat or inverts, historically it's not been a good sign for where you're going to be in the next year. A flat curve today tells you a year from now growth is going to be weaker."


For now, the economy appears to be strengthening, so flattening may not mean what it has historically, but there is still trepidation even though strategists point to very logical reasons behind the move.


LaVorgna, and a number of strategists, said the flattening curve is reflecting concern about the prospects for tax reform. While President Trump hopes to have a bill enacted by December, many in the markets see too many battleground issues in the House proposed bill for it to pass quickly.


"The yield curve is telling us that either the tax cut is not happening or it's not going to be expansionary," LaVorgna said.


But some strategists say the curve is really reflecting more the fact that the Fed is going to be raising interest rates at the same time there is no inflation — which is reflected by the declining 10-year yield.


In the past week, the 10-year has fallen to as low as 2.31 percent, well off the high of 2.47 percent last Friday. The 2-year yield, more reflective of Fed rate hikes, reached a high of 1.63 percent Friday, close to where it was a week ago. When the October jobs report showed no signs of wage growth Friday morning, the curve flattened further amid concerns that no wage growth means no inflation.


"The Fed is hiking, and inflation isn't there," said David Ader, chief macro strategist at Informa Financial Intelligence. "It's certainly an alert and a warning to keep an eye on the yield curve."


The U.S. Treasury market has also been influenced by foreign markets, especially German bunds. The European Central Bank continues to buy bonds under its quantitative easing program, and while it reduced the amount it extended the program. That has kept longer-term rates subdued.


So while the short end has risen on Fed rate hike prospects, the long end is not reflecting the potential for growth.


"The curve makes it look like a recession is around the corner, but it is not," said Larry McDonald of "The Bear Traps Report" newsletter.


McDonald said the pickup in U.S. economic growth on the back of better global growth will push the Fed to hike more. "[Powell's] going to hike faster than the market thinks," said McDonald. "The market is only at two hikes in 18 months, and he's going to deliver three or four."


McDonald said he expects the yield curve to revert to steepening. "I think the recession is probably late next year, but we're going to have a steepening first, and then a vicious flattening. The market is going to have to start factoring in global growth. The global growth is picking up U.S. growth," he said, adding when yields do rise high enough that could tip the U.S. into a recession.


Ader, however, said he only sees two rate hikes next year. He said the Fed may not see the inflation it is anticipating.


"If the Fed gets more aggressive then we could be talking about an inverted yield curve," he said.


"The assumption here is that everyone is expecting it. If we see another six months where it doesn't show up, that may cause them to pause," said Ader of inflation and the Fed.


Strategists say there's another factor at play in the bond market this week. The Treasury's refunding announcement Wednesday indicated that it was planning issuance at the lower end of the curve, 5-years and shorter, even after Treasury Secretary Steven Mnuchin said he was considering super-long-dated bonds, like 50-years.


"They're going to really front load the curve [with new Treasury issues], and now the Fed, under Powell or [Janet] Yellen, it doesn't really matter in the next year, they're going to raise rates, three times in the next 12 months and four times in the next 14 months," said Andrew Brenner of National Alliance. "Those things are going to flatten the curve, and they're going to flatten it so much that people could talk about inversion … between the supply and the Fed flattening big time."


He said the Treasury missed out on an opportunity to issue a long-dated Treasury at a relatively low yield. The Fed is expected to raise interest rates in December, but it has also embarked on a program to shrink its balance sheet by buying fewer bonds. "Maybe they're a little scared issuing at the long end. The Fed's going to be cutting back," he said.


Source: CNBC

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