Fed and the flat yield curve
The Fed seems likely to raise interest rates again in March and we think that three or four hikes in 2018 are reasonable given the tightness in US labour markets. There is not much room for moderation as tax cuts will boost growth at a time when there are already signs of overheating.
Sustained Fed tightening seems likely to cause the yield curve to flatten further. Although it is not our base case, it is possible that it is inverted (long-term interest rates lower than short rates) by the end of 2018.
In the past an inverted yield curve was often a sign of impending recession. As the chart shows, the yield curve has turned flat or negative ahead of all of the past nine US recessions, with only one false signal.
Inverted yield curve often signals recession
We need to ask why we normally worry about an inverted yield curve. The main reason is that it typically occurs when short-term interest rates are relatively high, which is what drives the risk of recession.
Long-term interest rates tend to be relatively stable, as they should reflect the expected path of short-term rates over time, plus a risk premium. The assumption is that over the life of a 10-year bond, short-term rates are around neutral for at least the second half of the period, and that provides an anchor for long-term rates.
In contrast, short-term interest rates rise and fall with the central bank’s efforts to manage the economic cycle. So normally a yield curve is steep when short-term rates are low and policy is stimulative. It is flat or inverted when short-term rates are high and policy is tight.
In other words, we should not just look at the shape of the yield curve, but also at the absolute levels of short- and long-term interest rates. The second chart mirrors the first, except that it simply shows the level of short-term (three-month) interest rates. It shows that recession typically follows a period of monetary tightening, where short-term interest rates rise sharply. Compared to history, so far we have not seen much tightening in the current cycle. The Fed has pushed through just five 0.25% rate hikes since December 2015.
Recession often follows a period of tightening
There are three reasons why recession is unlikely in 2018, even if the curve inverts. First, policy is still loose. The Fed thinks that 2.5-3.0% is a neutral level for the Fed Funds rate, so anything below that (rates are currently at 1.50%) is stimulative. Admittedly, we do not know exactly where the neutral level of interest rates lies, but we can see that policy is still loose by the strong performance of the economy and the buoyancy of risk assets. It probably starts to become tight in 2019.
In fact if we look at the financial conditions index for a measure of the policy stance, it is clear that the environment has become more stimulative over the past year, due to the weaker USD, rising asset prices and low volatility. Moreover, recession risk indicators are comatose.
US financial conditions (higher is looser)
Second, long-term interest rates are relatively low (compared to short rates) due to strong demand and abundant liquidity, rather than a pessimistic view about the outlook for growth. Regulatory change has increased demand for low-risk, long-term assets, while aggressively-loose monetary policy – not just in the US – has pulled yields down across the world, making US 10-year bonds yields at 2.5% look relatively attractive (with German Bunds at 0.5% and Japanese bonds stuck at zero).
This factor is likely to become less powerful over the coming year, as central banks in Europe and Japan reduce bond purchases. The scale of the change is evident in the chart below, with G3 central bank balance sheets set to peak in 3Q 2018.
Change in G3 central bank balance sheets
At the same time, the supply of bonds into the market is set to double. Fed balance sheet cuts will be in full swing before year-end (at an annual rate of $600bn, or 3% of GDP), while the government’s borrowing needs are heading higher due to tax cuts.
Third, there is a question of causality. An inverted yield curve might correlate with recession historically, but the cause is the high level of short-term interest rates. An inverted yield curve might discourage bank lending, as it reduces profitability, but this is not a significant factor. Surveys show that bank lending officers have not become more restrictive.
In fact we doubt the curve will invert over the coming year. The Fed is likely to hike only three or four times, while we expect 10-year bond yields to push up towards 3%. So the yield curve is set to be flatter, but not inverted.
Irrespective the shape of the yield curve, it is hard to see an imminent recession. US tax cuts should boost growth – especially investment – in 2018. There is more of a question over 2019 – by which time the curve could easily be inverted – and particularly 2020, if the stimulus from lower taxes presses the Fed to tighten more aggressively, and then a slowdown is compounded by the likely cuts to welfare benefits that will be the response to the wider US budget deficit. However, it seems too soon to be worrying, in early 2018, about the risk of recession in 2020.Disclaimer applicable to recommendation
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