Will they or won’t they? With the U.S. yield curve flattening to new cycle
lows, whether or not the Federal Reserve will stick to its planned
rate-hike path is a key question – and could soon become the key
question – for financial markets.
It is well-known that an inverted yield curve, as measured by the spread
between 3-month Libor and 10-year Treasury interest rates, has been a reliable
leading indicator of recessions over the past 50 years. To be sure, the
3-month Libor to 10-year spread is still positive at around 50 basis points currently.
However, unless 10-year yields rise, the curve could invert by year-end if
the Fed hikes rates another two times, as suggested by its own dot plot. So
will Fed officials ignore a potential curve inversion and keep raising
short rates beyond that point, or will they pause and adjust their forward
guidance to avoid a lasting inversion?
The Fed’s semi-annual
Monetary Policy Report to Congress issued on 13 July remained silent on this question. However, it
repeated the language that Fed watchers can recite while sleeping:
“The FOMC expects that further gradual increases in the target range
for the federal funds rate will be consistent with a sustained
expansion of economic activity, strong labor market conditions, and
inflation near the Committee’s symmetric 2 percent objective over the
So how many “further gradual increases” should we expect? A reasonable
assumption would seem to be that, provided the economic backdrop cited
above doesn’t change radically, the Fed will raise rates until the fed
funds rate reaches the neutral rate, defined as a level of rates that keeps
the economy growing on trend and inflation on target over the medium term.
OK, sounds good in theory, you may say, but where is neutral?
We at PIMCO have long argued that what we call
The New Neutral is somewhere between 0% and 1% for the real fed funds rate, which
translates to a 2%–3% nominal rate if inflation is at the 2% target.
Conveniently, a useful new table in the Fed’s latest Monetary Policy Report
that lists econometric estimates of the neutral real rate from seven
studies, mostly by Fed economists, confirms just that. The seven point
estimates of the neutral rate range from 0.1% to 1.8%, with a median of
0.7%. Assuming 2% inflation, this is very close to Federal Open Market
Committee (FOMC) participants’ 2.9% median estimate of the so-called long
run fed funds rate in the
June Summary of Economic Projections (SEP).
Yet, if the Fed would go to neutral as defined above, and if the 10-year
yield were to stay where it is currently, the curve would likely invert,
sending a recession signal. So again, how would the Fed react to an
inversion of the curve?
At this stage, only a few participants (among them regional Fed presidents
Raphael Bostic, James Bullard, Patrick Harker and Neel Kashkari) appear to
have made up their minds and have expressed serious concerns about a
potential curve inversion. Others seem more open to the argument that “this
time may be different”: With a low or even negative term premium depressing
longer-term interest rates, a flat or inverted yield curve may not signal a
recession this time, as the economy largely depends on intermediate to
long-term interest rates (which are very low) – or so the story goes.
I’m not convinced, for two reasons. First, Fed officials made similar
arguments when the curve inverted in the last cycle, before the global
financial crisis and Great Recession. At the time, they argued that curve
flatness or inversion could be ignored because a global savings glut kept
long rates low as the Fed hiked rates above neutral. That didn’t end well.
Second, when short rates rise above long rates for whatever reason, banks
will be less able or willing to engage in maturity transformation and
credit creation. In fact, work by our U.S. economist, Tiffany Wilding,
shows that the shape of the yield curve, with a two-year lead, has been a
good predictor of the credit impulse – the change in the growth rate of
bank loans – which in turn correlates highly with real GDP growth.
Yielding to an inverted curve
While the jury on curve inversion is still out, here’s my prediction:
Should the yield curve (defined as the 3-month Libor to 10-year Treasury spread) invert, I
would expect the Powell Fed to change gears and signal a pause in the
hiking cycle to avoid a lasting curve inversion. This decision would likely
be helped by an adverse reaction of risk assets to curve inversion and a
related tightening of financial conditions. More curve flattening in the
near term appears likely, as trade tensions look set to intensify further,
thus weighing on longer-term yields as the Fed keeps marching up the dot
plot; however, I don’t expect a lasting inversion, as the yield curve will
likely become part of the Fed’s reaction function once it inverts.
But what if I’m wrong, and the Fed allows the curve to invert in the belief
that this time is different? In this case, I’d be even more convinced that
the next recession as early as 2020 – which of course would likely be the mother of all curve
steepeners yet again.