Whose afraid of an inverted yield curve now?

A few weeks ago, there was much discussion of the risk of an inverted yield curve. The surge in 10 year yields since August has reduced those fears although plenty of people think it might be temporary. They fear the Fed will prove too aggressive and kill off the 9 year-old upswing point to the yield curve. Three more Fed hikes (from 2.25% today), on which the Fed now seems intent, combined with a small fall in the 10-year yield (3.2% today) would take the spread between the funds rate and the 10 year yield to zero or negative. And a recession always follows, right?

Well, almost always. In June 1998 the yield curve went negative and stayed there (mostly) for about 6 months but then turned positive again. Recession was still 3 years away. And it nearly went negative in 1995 after the Fed raised rates sharply and the economy slowed for a time.

Even if a recession does soon follow it will not be immediate. On past form it takes 12-18 months or more. In the 2000s upswing the spread hit zero in March 2006, then lifted above for a couple of months before going through zero again in May 2006 and heading further south after that. That was 20-22 months before the recession started in January 2008. Going further back the yield curve inverted 11 months before the 2001 recession, 17 months before the 1990 recession and 14 months ahead of the 1980 recession. The picture is similar if you measure the yield curve using 2 and 10 year yields.

Still, if short rates go above long yields doesn’t that mean that the bond market is saying that higher rates won’t stick – in other words another recession is definitely coming? OK, but how much should we worry about that right now? Not much I think, for several reasons.

First, we are not there yet. True, the FOMC projections suggest the Fed expects to reach 3% for Fed Funds rate in 2019 and then 3.25-3.5% by end 2020. But it won’t go there if growth falters or inflation falls back. And assuming we get 1 more hike this year, the pace of hiking will definitely slow in 2019-20. It would only therefore require a fairly small further rise in 10 year yields to keep the yield curve positive. Say 50 basis points or so. It is easy to tell a story where inflation picks up a little in the next year, for example to the 2.3-2.5% range. Then the bond market’s reaction will depend on the Fed’s response. If the Fed becomes very hawkish and hikes rates more aggressively, an inverted yield could soon follow. But what if it remains gradualist and talks more of tolerating a small missing of the target? The current make-up of the Fed could easily put us there. And if the economy comes off the boil slightly, with GDP growth easing back to say 2%, most people would probably think that was fine. Except the bond market which would surely want yields a little higher, probably to the 3.5-4% range, if the Fed is smiling benignly at 2.5% inflation.

Secondly the Fed’s suspicions that the 10 year yield is being held down by special factors seems plausible. What are these special factors? One is the very low yields in safe European assets, for example 10-year Bunds still at only 0.56%. Another is the continued search for safe assets by long term pension and insurance managers as well as banks, driven by regulations pushing them in this direction. A third is that although the Fed has begun to wind down its balance sheet it is still holding at least $2 trillion of excess government and MBS securities.

Third, the current rates path looks much less restrictive than when the yield curve inverted before. Approaching the last three recessions the real Fed funds rate at the point of yield curve inversion was 5% in 1989, 4.3% in 2000 and 2.5% in 2006. (I am using the core consumer expenditure deflator here.) Surely in 1989 and again in 2000 we would agree that policy was tight at this point, so a recession following was not too surprising. In 2006 real rates went on up to just above 3% on this measure, which at the time was not seen as far above ‘neutral’ but, some argue in fact was, as evidenced by the subsequent recession.

But that assumes that the 2008 recession was caused by high rates, which is questionable. Arguably it was caused by the dual shocks of the doubling in oil prices and the financial crisis. The riposte might be that the financial crisis at least was caused by high rates, which pricked the housing bubble. But I think that is questionable too. In my view the bubble developed because of excessively low rates in 2001-5, along with a host of other institutional factors. Housing in the sand states was a speculative bubble and it was going to burst at some point whatever the interest rate.

This time, if we get an inversion after 3 more rate hikes (to 3%) the real Federal Funds rate is going to be less than 1% (unless you think inflation is headed down). If the inversion occurs sometime in 2019 when the funds rate hits 3.5%, the real rate will still be only about 1.5%. Too high? Is the neutral rate today well below 1.5%? Perhaps, but this is not obvious.

So, my reading is that the Fed is on a sensible path and is not going to kill the upswing on its own. Indeed we probably won’t see the yield curve invert this year, or even next, because 10 year yields will drift higher as wages and inflation gradually gather pace. Even if we do, those special factors mean that the dreaded recession still might not come. And if it does? Remember that historically, when the yield curve first goes inverted you still have 12-18 months to plan.