What About The Risk Of A U.S. Yield Curve Inversion?

“There is a material risk of yield curve inversion over the forecast horizon if the FOMC continues on its present course of increases in the policy rate. It is possible that yield curve inversion will be avoided because longer-term nominal yields will begin to rise in tandem with the policy rate, but this seems unlikely as of today. Given below-target U.S. inflation, it is unnecessary to push normalization to such an extent that the yield curve inverts.“ (James Bullard, Assessing the Risk of Yield Curve Inversion, Regional Economic Briefing Little Rock, Ark, Dec. 1, 2017)

On December 13th the U.S. Federal Reserve increased its key policy interest rate for a third time in 2017. The markets were well prepared for the latest rate hike, which brings the top range for the federal funds rate to 1.5%.

This much anticipated policy move immediately raised short term Treasury yields, but the upward shift at the short end was not matched by an increase in longer-term Treasuries.

While some further flattening out of the yield curve was widely expected, it also has raised concerns that at some point next year the yield curve could invert, resulting in a new recession.

Historically an inverted yield curve (which has a 2-year yield above a 10 year or 30-year Treasury bond yield) has heralded most economic downturns since the middle of the last century. However, as James Bullard of the Federal Reserve observed in a recent speech, history does not always repeat itself in the same way.

In most cases when the yield curve inverted, the Fed deliberately chose to cause a downturn, if not a mild economic slowdown. Currently the Fed has no desire to cause a recession, since the legacy problems from the last Great Recession are still evident around the world.

The Fed currently is pursuing normalcy in financial markets, rather than a new recession. As long as the Fed continues to warn the markets long in advance of future rate hikes, there seems to be no obvious easy reason to expect a Fed induced recession.

Rather, if there is a recession on the horizon, this economist would place greater odds that it would be traced to an external event, likely international in origin, than an overly tight U.S. monetary policy.

Finally, the Fed is not the only central bank attempting to normalize financial conditions and interest rates. Other major central banks are either also raising rates or, as in the case of the ECB, are at least preparing the markets that it will do so in the not too distant future.

The ECB has been tapering back on its quantitative easing, and recently announced that it will purchase only €30 billion worth of bonds beginning in January 2018. The ECB intends to keep this monthly purchase rate unchanged through to at least to next September.

The Bank of England decided on November 2nd to raise its policy rate 25 bps, but will likely remain on hold in 2018 due to Britain’s risky economic outlook tied to the Brexit negotiations.