The Federal Reserve Bank and the bond market are at odds over the outlook for the U.S. economy and inflation.
Despite two hikes of the Federal Funds rate this year, ranging between 1.75 percent and 2.0 percent, long-term rates have not kept pace, causing the yield curve to flatten and stoking fears of a recession.
“[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.”
Like many market analysts, Rusnak is troubled by the flattening yield curve. 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 2-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.”
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.
“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.
There is also the rest of the world to consider. The U.S. economy is currently far stronger than most other developed markets. While the Fed is unwinding its accommodative monetary policy, other central banks are still propping up their economies with ultralow interest rates and quantitative easing programs. The 2.9 percent yield doesn’t seem like much for a 10-year commitment, but it’s a bonanza compared to the German 10-year bund, which currently yields 0.33 percent. Foreign demand will put a ceiling on how far and fast the 10-year U.S bond yield moves.
Rosenberg does not expect the yield curve to invert this year, but if it does, he suggests investors should take it with a grain of salt. “We need to respect the risk [of a curve inversion], but there are a lot more factors involved,” he said. “We may need to see a deeper inversion before we can evaluate what it means.”
For its part, the Fed could be forgiven for its enthusiasm to play its traditional role of inflation fighter for the first time in a decade. The resurgent economy has finally presented the opportunity to normalize monetary policy. Every rate hike it makes now and every $1 billion in government bonds that rolls off its balance sheet provides the Fed with more ammunition in the next recession. Good news, as long as it doesn’t send the economy back into the tank.
“It’s one thing to prepare for the next downturn, and another to cause the next downturn,” said Wells Fargo’s Rusnak.