Yield curve inversion in the US when the Fed hikes
This is going to be a brief post on another of my potential ten surprises for 2015. The thesis here is that, with two year rates at 0.52%, all we need to invert the yield curve is a 50 basis point hike. While there is considerable disagreement over when and whether the Federal Reserve will raise interest rates, because this is an important policy decision, looking at the yield curve implications of such a hike makes sense. I don’t have a conviction here. So this analysis is somewhat speculative. But I think it will make sense.
I have been thinking about where we are in the economic cycle and how the economy will respond to Fed policy. And going through Fed policy choices, it occurs to me that they are limited because of the over-reliance on monetary policy for stimulus. On the one hand, it is clear we have had a mal-distribution of investment capital, with too much going into speculative shale oil ventures. We are also probably seeing a new wave of Internet and VC financing that will end in a wave of consolidation and failure in that industry. Katie Benner is good on this topic. Overall, I would say so-called malinvestment is high at this point in the credit cycle. Moreover, after a monster run up since 2009, stocks by most measures are overvalued. And I tend to believe that the Fed’s adherence to a zero nominal rate monetary policy has helped create these distortions. See Matt Klein on this.
But all of this is the financial economy. In the real economy – which is much less controlled by monetary policy, by the way – the situation is not as robust. Job growth is now at cyclical high and jobless claims at a cyclical low that is supportive of a 3%ish number on annualized real GDP growth. And debt service costs are at secular lows, giving households breathing room in case of economic distress. However, the lack of real wage growth should be a deep concern, until we see the unemployment rate even lower than it is today, say 4.5%. In this real economic environment, given the lack of consumer price inflation, it does make sense for the Fed to remain on hold.
But the Fed is probably not going to remain on hold. In the suboptimal world in which we live in which monetary policy rules the roost, the Fed is expected to do it all: maintain price stability and support full employment as a dual mandate. And increasingly the Fed has a stealth third mandate: maintain financial stability. It is this stealth third mandate which makes rate hikes likely. And I believe the macro data are robust enough that we will see hikes in June unless the macro environment really deteriorates. By June, we could be at 5.1 or 5.2% unemployment, with trailing 12-month average monthly job growth of 250-275,000. Irrespective of where inflation is, unemployment would be well past a level that traditionally has drawn a response from the Fed. If one looks at the Taylor Rule as a guide, the Fed should be hiking already. Again, I think the real economy is weaker than the headline suggests because of poor wage growth and still high private debt levels. But the conundrum is that imbalances are building and the headline employment situation is already at a place where the Fed is expected to raise rates.
In my view, the Fed never should have moved to zero rates to begin with. But because they are there and because they want to normalize policy, there is more pressure on them to raise interest rates than were rates at 1 or 2%. But what happens if the Fed raises rates? Yesterday, I wrote at considerable length about the convergence of safe asset yields toward zero. The gist is that a host of factors suggest longer-term yields will remain under pressure. Low inflation or deflation and the bid for safe assets will anchor long-term interest rates irrespective of what the Fed does on the short end. With two-year yields at 0.52%, what happens then when the Fed pushes up rates to 0.50%? Initially, these rates will go up as well, but less because of the safe asset, low inflation bid. Perhaps they would rise to 0.65 or 0.70%. But once the global growth slowdown infects the US and the ill effects of the oil sector slowdown start to be felt, there is a chance that these yields will fall toward their original level, making curve inversion a possibility.
An inverted yield curve is a sign of impending recession and here one could argue that an inversion would be the result of Fed policy. But anchoring at zero was a mistake and it can’t be undone now. The easiest way out for the Fed is if GDP growth in the US stalls. That would give the Fed an excuse to put a rate hike on hold. With the 10-year falling to 1.80% and the dollar rising to 1999 levels against the euro, the Fed has an excuse to stay at zero, but I don’t think they will. And if they did, financial imbalances would grow as investors extended their reach for yield and move into riskier assets to make up for the lack of yield they are getting on fixed income investments. The options are narrowing here and that’s because the Fed is the only game in town.
I’m going to end it here for now. But I plan to return to this topic in the coming weeks as more data come to light.