Despite two hikes of the Federal Funds rate this year, ranging between 1.75 percent and 2 percent, long-term rates have not kept pace, causing the yield curve to flatten and stoking fears of a recession.
Just about every time the U.S. Treasurys yield curve has flattened in the past, the U.S. economy has tanked shortly afterwards. Yet Federal Reserve chairman Jerome Powell told Congress that he intends to keep gradually raising interest rates "for now.”
“[Federal Reserve Bank] Chairman Powell is bullish on the economy, but we’re concerned he’s overly bullish on the pace of rate hikes,” said George Rusnak, co-head of global fixed-income strategy at Wells Fargo. He worries that a newly aggressive Fed could hasten a downturn in the currently strong economy. “The market doesn’t think the future growth and inflation are there.”
Adam Jeffery | CNBC
The U.S. Federal Reserve building in Washington, D.C.
Like many market analysts, Rusnak is troubled by the flattening yield curve.
Markets could be in panic mode by late next year if the flattening yield curve turns into a full-on inversion, but it won’t turn into a massive sell-off, Erin Browne, head of asset allocation at UBS Asset Management, told CNBC.
She believes the indicator will continue to flatten and invert in late 2019, causing major stress among market players, who will be wondering whether or not a recession is about to kick in. Investors, however, should not take the inversion as a sign of an impending recession, Browne told CNBC.
The curve plots the interest rates of Treasury bills and bonds against their duration. In a healthy economy the curve slopes upward and investors are paid more to lend money for longer periods as reward for taking the risk that inflation and interest rates will move higher.
When spreads between short- and long-term rates narrow, it suggests that the market believes economic growth and inflation are not sustainable and will fall in the future.
The spread between the yields of the two-year Treasury note (2.55 percent) and 10-year Treasury note (2.89 percent) was 34 basis points on June 23. That’s less than half of what it was in early February and the narrowest it’s been since August 2007. An inversion of the curve — when long-term rates fall below short-term — traditionally indicates a looming recession. The newly appointed Fed Chairman is already facing criticism for increasing that risk.
“Chairman Powell is being too bold as head of an institution that requires careful management,” said Guy Petcho, global macroeconomic portfolio manager for Voya Financial. “The Fed is dismissing the signal of the market, but the market will force it to pay attention.”
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An inverted yield curve spooks investors a lot more than the Fed. Every recession since the 1950s has been preceded by a curve inversion. While the lag between inversion and recession has varied between six months and two years, the one has always followed the other, with only one exception in the mid-1960s.
“Historically, an inverted curve has been the single best indicator of market expectations,” said Thanos Bardas, a managing director at Neuberger Berman. “The pattern moves from higher inflation to excessive tightening to an inversion and then a recession.”
Normally, the Fed intends for that pattern to occur in order to slow an overheating economy. With inflation finally trending near the Fed’s stated target of 2 percent, however, it can hardly be characterized as high. Bardas, too, believes that the Fed should be responsive to market forces and not risk an inversion of the yield curve. “If the curve continues to flatten, the Fed may need to pause [its rate hikes],” he said.
Why is the yield curve flattening? The simple answer is the rapid rise of the 2-year Treasury yield. It has risen much faster than changes in the Fed funds rate because the market now believes that the Fed’s policy path is more certain given the strong economy.
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“We’ve had eight years of growth consistently coming in under estimate,” said Jeffrey Rosenberg, chief fixed-income strategist for BlackRock. “Now GDP growth is exceeding the Fed’s expectations and the market is adjusting by narrowing the uncertainty discount.”
The three-year forward Fed funds rate is now at 2.7 percent, meaning the market expects the Fed to raise rates three more times this cycle. The 2-year Treasury yield has priced in most of the expected Fed tightening. While Fed policy is the major mover of the 2-year Treasury yield, a wider range of factors are influencing the behavior of the 10-year bond.
For one thing, the Fed and central banks around the world have been buying up government debt for years, effectively depressing long-term interest rates. The Fed is now reducing its holdings of government bonds by not reinvesting a growing volume of maturing bonds. The pace of the unwind is currently $30 billion per month and will rise to $50 billion in the fourth quarter.
The lower demand will ultimately serve to reduce prices on long bonds and raise yields, but the passive strategy is having an unintended impact on the yield curve, said Rosenberg. As near-term maturities roll off the balance sheet, the short end of the curve is not getting support while the government continues to hold its longer-term bonds. “It’s effectively still Operation Twist,” said Rosenberg, referring to the Fed’s strategy of selling short-term Treasury bills to buy long-term Treasury bonds first implemented in 2011. Much of the Treasury’s issuance of debt so far this year has been in the form of short-term bills, adding further pressure for the yield curve to flatten.
