Is The Fed Tilting The Yield Curve All By Itself?

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Notice anything about the below chart? Correct, you see that whenever the value derived by subtracting the interest rate of the US Treasury 10-year bond from the US Treasury 2-year note gets to or below zero, a US economic recession occurs. If you look to the far right, you can see that the trend for this value is headed towards that ill-fated condition.

10-Year Treasury Maturity Minus 2-Year

The Federal Open Market Committee (FOMC) wrapped up their December meeting on the 13th announcing that they are hiking the Fed Funds rate by 0.25%, in a well telegraphed move. The FOMC also released their dot plot chart, which it uses to help signal the Fed’s outlook for the path of interest rates over the next couple of years. Reading the tea leaves from the text from the December meeting, and the dot plot shown in the following chart, consensus suggests the Fed plans to hike rates three times in 2018. This upward pressure on the short end of the U.S. yield curve by the Fed may have broader implications for the economy and markets.

FOMC 2017 - 2020 Forecast

The Fed pushing up short-term rates isn’t unusual by itself, but in today’s environment the Fed seems to be helping to tilt, or flatten, the U.S. yield curve. Recently people have been questioning whether this may lead to a yield curve inversion. A yield curve inversion is where shorter-term yields are higher than longer-term yields. The reason for so much concern is that yield curve flattening precedes yield curve inversions. In the past yield curve inversions have typically preceded modern-day recessions. However, not every yield curve inversion is followed by a recession. In the following chart, we can see how much the yield curve has flattened from year-end 2016 until the day after the FOMC made its December rate hike announcement.

Treasury Yield Curve

In the chart, we can see that short-term yields have risen, thanks to the Fed, but we can also see that longer-term yields have fallen. The curve is flattening, and if the Fed hikes short-term rates three more times in 2018, we could find ourselves with an inverted yield curve.

An inverted yield curve means that investors have little confidence in the economy. They would prefer to buy a 10-year Treasury note and tie up their money for ten years even though they receive a lower yield than available with short-term rates. That makes no logical sense. Investors typically expect a higher return for a long-term investment. Therefore, this means investors believe they will make more by holding onto the longer-term bond than if they bought a short-term Treasury bill. That’s because they’d just have to turn around and reinvest that money in another bill. But if investors believe a recession is coming, they expect the yield of the short-term bills will fall sometime soon. Therefore, investors want to lock in long-term rates at current levels, even if those long-term yields are lower than short-term yields now. The implication is that Fed will lower the fed funds rate when economic growth slows leaving the investors holding long-term bonds sitting pretty.

While yield curve flattening, followed by yield curve inversion, has often been a portent of recessions in the past, we do not believe that this is the case this time.

While yield curve flattening, followed by yield curve inversion, has often been a portent of recessions in the past, we do not believe that this is the case this time. The economy is strong, with the second estimate for 3rd quarter GDP being raised 3.3%, brisk jobs growth as seen in 228,000 November Non-farm Payrolls number, and the FOMC just raised its economic growth outlook for 2018 at its December meeting. Also, Tax Reform legislation is on the horizon. Each of these will help give the economy a boost, so it seems rather unlikely that a recession is on the horizon, despite the length of the current economic recovery.

Why then is the yield curve flattening? Or more precisely, why are long-term yields falling while the Fed is hiking short-term rates? Normally, if US investors suspected a recession was on the horizon, they would be locking in long-term rates before the Fed lowers short-term rates in the face of that recession. So, if a recession isn’t looming in investor’s minds, why are investors locking in long-term rates as the Fed is hiking short-term rates?

We believe that world-wide quantitative easing, pushing world-wide long-term rates downward, has left foreign investors with few places to find a good return. The US 10-year yield offers a substantial premium to 10-year yields in the United Kingdom, Germany, and particularly Japan. In the following chart, the disparity in 10-year yields is readily apparent. Therefore, foreign investors, not U.S. investors, hungry for yield are deploying capital into US government debt markets helping to push down long-term U.S. yields.

10-Year Treasury Yield

Therefore, we believe that longer-term US rates are not falling because of fears of lower economic growth, or recession. We feel the appetite by foreign investors for the comparatively higher US yields is what is causing the US yield curve to flatten, maybe even invert. But we do not see this as a portent of an imminent recession.

The outlook for the U.S. economy looks quite bright and the opportunities in the markets are promising. In this instance, we do not feel there is a need to worry about the yield curve.

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