Last week St. Louis Fed President James Bullard and Minneapolis Fed President Neel Kashkari warned against further rate hikes by the Federal Reserve, contending they increase the risk of an inverted yield curve, which historically has indicated an impending recession.
An inverted yield curve, which occurs when short-term rates are higher than long-term rates, is not the norm. Historically, inversions occur in the latter part of an economic growth cycle — we’re in the 10th year of one currently — when the Fed continues to raise rates to offset rising inflation and investors anticipate the hikes will slow the economy. Long rates fall or remain unchanged while short-term rates continue to rise, eventually topping long-term rates.
The curve hasn’t inverted yet, but it’s getting close.
The current spread between the federal funds rate and the 10-year Treasury note yield is 95 basis points, when using the upper end of the fed funds range (2%). A year ago, before three subsequent rate hikes, the spread was 101 basis points. Typically during periods of continued economic growth the spread is 250 basis points or more.
The spreads between the two-year and 10-year Treasury yields has also narrowed, to 32 basis points from 91 basis points a year ago.
Mark Zandi, chief economist of Moody’s Analytics, writes in his latest macro report that the spread between the fed funds rate and 10-year Treasury yield — what it calls the “policy yield curve” — is the “most prescient” in anticipating a recession, but the 2-year/10-year Treasury spread has also been “a foolproof leading indicator in recent business cycles.”
He says a “fully inverted curve seems plausible as soon as this time next year,” if the Fed continues “to normalizes policy more quickly in response to massive fiscal stimulus and the resulting threat of an overheating economy.” A recession typically follows one year after the curve inverts, writes Zandi.
But some economists, including former Fed Chair Ben Bernanke and current Fed Chair Jerome Powell, a former banker, aren’t convinced that an inverted yield curve in the current macro market suggests a recession is coming.
At a recent event focused on the financial crisis, Bernanke said, “Historically the inversion of the yield curve has been a good [sign] of economic downturns [but] this time it may not,” because of market distortions due to “regulatory changes and quantitative easing in other jurisdictions … Everything we see in terms of the near-term outlook for the economy is quite strong.”
He was referring in part to continued asset purchases by the European Central Bank and Bank of Japan putting global long-term rates, including those of the U.S., under pressure.
Powell, in a recent appearance before the Senate Banking Committee, also downplayed the significance of an inverted yield curve. In an answer to a senator’s question, he suggested that the decline in long-term rates indicates the market’s view of how far the Fed is from achieving a neutral rate policy, where rates are neither too low to be inflationary nor too high to slow the economy.
“People look at the shape of the curve because they think that there’s a message in longer-run rates — which reflect many things — but that longer-run rates also tell us something, along with other things, about what the longer-run neutral rate is. That’s really, I think, why the slope of the yield curve matters.”
Zandi doesn’t buy Bernanke’s or Powell’s arguments.
“The bottom line is that the ability of the yield curve to predict turning points in the economy is probably as good today as it has been in the times past. Ignore those voices that claim this time is different. It very likely is not.”