Flattened yield curve reason to be nervous, but U.S. economy solid: Fed's Evans

2/2 © Reuters. Charles Evans, president of the Federal Reserve Bank of Chicago, poses for a photo in Palm Beach 2/2

By Noah Sin

HONG KONG (Reuters) - Chicago Federal Reserve Bank President Charles Evans said on Monday it was understandable for markets to be nervous when the yield curve flattened, though he was still confident about the U.S. economic growth outlook.

In what many see as a bad omen for the economy, yields on benchmark U.S. 10-year treasury notes fell below three-month rates on Friday for the first time since mid-2007, an inversion that has in the past signaled the risk of recession.

After an unexpected rise in the Ifo Institute's March business climate index in Germany, spreads between U.S. three-month and 10-year Treasury yields turned positive.

Evans described the inversion as "pretty narrow".

"We have to take into account that there's been a secular decline in long-term interest rates," Evans said in comments at the Credit Suisse (SIX:CSGN) Asian Investment Conference in Hong Kong, days after the Fed signaled an end to its tightening and abandoned plans for further rate hikes in 2019..

"Some of this is structural, having to do with lower trend growth, lower real interest rates," he said. "I think, in that environment, it's probably more natural that yield curves are somewhat flatter than they have been historically."

On the sidelines of the conference, Evans told CNBC in an interview that he could understand why investors were more "watchful, waiting and looking," adding the Fed was doing the same. But, he added, economic fundamentals were "good" and he expected growth to be around 2 percent this year.

"Your first reaction is gonna (be) 'wow, this is less than what we had' and I think this is missing the message."

The risk of a shock hitting the economy was not unusually higher or lower at the moment, he later told reporters.

Speaking at the same event, former Fed chair Janet Yellen said the yield curve may signal the need to cut interest rates at some point, but it does not signal a recession.

"In contrast with times past, there’s a tendency now for the yield curve to be very flat," Yellen, who led the Fed between 2014 and 2018, said.

TIME TO PAUSE

On the monetary policy outlook, Evans told the conference it was a good time for the U.S. central bank to pause and adopt a cautious stance, adding he did not expect any interest rate hikes until the second half of next year.

He said the labor market remained strong, but noted inflation expectations had edged lower and there were risks related to weaker economic activity in China and elsewhere, uncertainty over Brexit, and a waning impact of U.S. fiscal stimulus.

Softening his tone from a few months ago, Evans, who votes on interest rate policy this year, said monetary policy was neither accommodative, nor restrictive at this point.

"I see things impeding inflation a bit, and I want to see inflation get up. So my own path is not to expect a funds rate increase until next year, probably, the second half," Evans said.

And even if prices do start to rise, he said, "given how muted inflationary pressures appear today, a rise to 2.25 to 2.5 percent is not a big concern to me at the moment."

That assessment suggests Evans has set the bar fairly high for further rate hikes, considering that inflation by the Fed's preferred gauge has not been that much above the Fed's 2-percent goal since before the financial crisis.

He added that with downside risks looming and uncertainties rife, it is prudent for the Fed to wait for more economic data.

He also said a rate cut was a possibility if the economy softened even more or inflation ran too low.

That echoed the view of fellow policymaker Atlanta Fed President Raphael Bostic, who on Friday said both possibilities are on the table for him.

In January, Evans said the Fed could hike interest rates three times in 2019 assuming the U.S. economy remained reasonably strong.

Last week, the U.S. central bank left rates steady in a range of 2.25 percent to 2.5 percent. Fresh forecasts showed 11 of 17 Fed policymakers expected no rate change for the rest of the year, up from just two in December.

That unexpectedly dovish signal had financial markets quickly pricing in a rate cut next year.