Change is in the air at the Federal Reserve. Chairman Jerome Powell’s semiannual monetary policy testimony in the Senate gave a big hint that we can no longer count on the explicit policy of gradual interest-rate hikes to continue too much longer. That doesn’t mean gradual rate increases will end, only that the Fed will rely less on forward guidance. A slower or faster pace of hikes, an extended pause, or even a rate cut are all possibilities at this point.
Bond markets are caught between a Federal Reserve determined to push short rates higher while demand stays strong for longer dated safe assets. The result is a relentless flattening of the yield curve. It is now easy to see the 10-2 spread inverting by then end of the year, an event that has traditionally been the harbinger of recession.
An inversion would certainly raise my attention with regards to the possibility of recession, but be careful on the timing. The 10-2 spread is a long leading indicator. The earth will not shake when that spread inverts. There will not be a plague of frogs. Blood will not rain from the sky. From the perspective of policy makers, the lack of immediate economic implication means it can be easily dismissed. And in my opinion that dismissal is the soil in which the seeds of the next recession are sown.
Last week the interest rate spread between ten- and two-year Treasuries narrowed to a cycle low of 25 basis points. Such narrowing is a typical characteristic of a tightening cycle as short-term rates respond more quickly to monetary policy moves than long-term rates. This cycle has been no different. Despite tighter policy, an economy near full employment, quantitative tightening as the Fed reduces the balance sheet, and a fiscal budget situation that promises to deliver massive new bond supply, the long end of the yield curve remains locked to roughly three percent.
You have every reason in the world to believe that selling the long end of the yield curve should be a winning strategy yet that has not been a good bet. The demand for safe assets yielding a meager three percent for 30 years is apparently unquenchable.
Moreover, growing angst over the trade wars (and arguably rising global instability on all levels) only drives more interest in safe assets. This signals to me that the disruptive impact of the trade wars will eventually yield a disinflationary outcome. Any inflationary consequences would be quickly snuffed out by central bankers.
Meanwhile, the Federal Reserve continues to signal its intent to push short-term interest rates higher. The US economy retains sufficient momentum for central bankers to justify moving policy rates closer to their estimates of neutral. The Fed is not yet worried about inflation, but believes that absent moving closer to neutral, inflation or financial instability will eventually arise in an economy running this hot. Federal Reserve Chair Jerome Powell provided this assessment in a recent interview with Marketplace:
As unemployment came down and inflation began to move up, we began very gradually increasing our policy rate, which affects rates throughout the economy and tightens financial conditions.
So we’re returning rates to a more normal level. If we leave rates too low for too long, then we can have too high inflation or we can have asset bubbles or housing bubbles. If we move too quickly, then we can unintentionally put the economy into a recession or cut off the return of inflation at 2 percent. So we’re always balancing those two things. I think for many yeåars there was nothing to balance, we had to keep rates low. I think as the economy’s gotten healthy, now we’re into balancing those two things we’ve got to steer between.
This view underpins the Federal Reserve’s strategy of gradually raising interest rates. And the data flow provides no reason for them to change that strategy just yet. While rebounding, inflation still remains sufficiently contained to preclude a faster pace of rate hikes. At the same time, fears of trade wars are not yet sufficient to justify pausing rate hikes in an economy that still generates 200k new jobs a month.
Overall, given the Fed’s policy direction, the strong underlying demand for safe assets, and the potential and increasingly likely disruptive impacts of a trade war, I find it difficult to expect anything other than continued flattening of the yield curve.
Now, I want to make clear that I don’t see a flattening yield curve itself as a problem. Indeed, a flat yield curve is perfectly consistent with continued expansion. The distinction between flat and inverted is actually a source of much confusion. For example, at the last FOMC meeting, policy makers were presented with the results of research downplaying the relevance of the 10-2 spread, in which the authors’ begin with:
Commonly cited measures of the term spread, such as the difference between the 10-year and 2-year nominal Treasury yields, have dropped over the past several years (Figure 1, blue line), a trend that has raised concerns and provoked extensive commentary in the financial press. Those concerns owe to the statistical power that low levels of term spreads have shown for predicting historical recessions over the subsequent year or so.
No, low levels of the term spread do not predict recessions. Only inverted curves predict recession. Once you recognize this misunderstanding, you can see why the authors’ approach of using a probit model to assess recession probabilities is problematic. A low term spread is very difficult to distinguish from a small inversion, and since there are many, many outcomes of a low level of term spreads that do not predict recession, the recession signal in such a model from even an inverted yield curve is fairly weak. Moreover, the authors only test predictive power up to four quarters out. This is unfortunately too strict as the signal could be as much as two years early.
In any event, this research adds to the list of reasons why the Federal Reserve is inclined to ignore any recession signal that comes from an inverted yield curve. The primary reason is that the inversion occurs well before an expansion ends, a time when the data flow tends to look about as good as might be expected (see today’s retail sales report) and when it appears inflationary pressures are building. Secondary reasons are the low term premium (which again has remained low despite quantitative tightening and fiscal stimulus), the belief that the level of rates is the important factor, and of course everyone knows that the Fed has never caused a recession at such a low level of rates.
Now all of these reasons might be correct and the Fed should ignore the yield curve. Fair enough. This time might in fact be different. That said, until proven differently, I continue to think that an inverted curve signals that monetary policy is either just right or too tight relative to that consistent with continued growth. This is irrespective of the level of rates.
So maybe a slightly inverted 2-10 spread is just right. Hence an inversion does not need to signal a recession, correct? Yes, I would agree with that. I think the odds of recession should rise if the Fed continues to hike rates after the 10-2 spread inverts. Indeed, the Fed tends to continue hiking after the 10-2 spread inverts. This was not the case, however, in 1998, when the inversion was greeted by the Fed with a rate cut.
I fully expect the Fed will continue hiking rates if the yield curve inverts unless there is a clear financial meltdown at that time. For the reasons above, Powell & Co. will find it impossible to resist the siren song of the data near the peak of a business cycle. When the hikes continue after the yield curve inverts is when I go on recession watch.
But again, timing is everything. Because the inverted yield curve is a long leading indicator, equities easily might continue to rise in the period after the inversion but before the recession. Hence, the inversion would likely be a premature “sell equities” signal.
Bottom Line: The U.S. economy retains substantial momentum, easily sufficient for Powell & Co. to stick with their gradual plan of gradual rate hikes. That plan has to date flattened the yield curve just like in every tightening cycle as long rates have held stuck near three percent despite every reason to think they will move higher. I don’t expect this situation to change, and hence expect that on the curve will continue to flatten as long as the Fed continues to hike rates. An inversion is likely at some point in the foreseeable future. The Fed is likely to continue hiking after that inversion – and that is the point at which I would look for storm clouds on the economic horizon.
The 10-2 spread flattened further this week. I will tackle that topic this upcoming Monday. Until then…
Under the leadership of former chair Janet Yellen, the Federal Reserve successfully identified 2017’s slowdown in inflation as transitory. Now with tariffs threatening to accelerate inflation, the Fed faces the opposite question: Is faster inflation just another transitory phenomenon? If Yellen’s successor, Jerome Powell, can’t repeat her ability to distinguish between persistent and temporary inflationary forces, then expect the ride to get much bumpier, ending with either a recession or high inflation — or a combination of both.
The day of reckoning for the Fed may soon be at hand. With the yield curve continuing to flatten and the 10-2 spread falling to a meager 33 basis points this week, an inversion before the end of the year is not out of the question. At that point, the Fed will need to choose between sticking with their current rate path or heeding the recession warning of the yield curve and pausing or perhaps even cutting. The latter option could send stocks higher while recession lurks behind the former.
Money flew to the safe haven of U.S. treasuries this week as investors weighed the potential impact of trade wars and shied away from stumbling emerging markets. With the Fed still signaling further rate hikes, the weight of these flows fell on the long end of the yield curve instead, pulling down the gap in rates between 10 and 2 year treasuries to just 33 basis points.
The flattening of the yield curve by itself does not necessarily indicate trouble ahead. It’s inversion (a negative spread) or nothing when it comes to using the curve as a recession signal. But we are moving closer to an inversion, close enough that an inversion this year cannot be ruled out.
How will the Fed react to a yield curve inversion? They can heed its warning as arguably the most reliable recession indicator or decide this time is different. If this time is not different and the yield curve signals recession in the making as in the past, then continuing rate hikes would be a clear policy error that would tip the economy into recession. Undoubtedly, that recession would weigh on earnings and by extension equity prices. And tripping the economy into recession would likely put monetary policy back into unconventional territory as the Fed’s interest rate tool lacks the 500 basis points needed to address a recession.
Alternatively, the Fed could shift to a wait and see mode if the yield curve inverts. As I argued this week, Federal Reserve Chairman Jerome Powell does not appear sufficiently concerned about inflation to keep hiking rates if the economy stumbled or was threatened by financial unrest. That’s would be good news for stocks. Recall that the stock market soared after the Fed stopped hiking rates in 1995 after a flat 1994. Taking a recession off the table would almost certainly support expectations of higher future earnings.
But which choice will Powell & Co. make? It is not clear that central bankers would see an inverted yield curve as a sufficient threat to the recovery to revisit their rate hike plans. Importantly, consider the current economic environment. In the second quarter, growth might exceed 4 percent at a time when the unemployment rate is already 3.8 percent. Even with inflation low and stable, there will be enormous pressure on the Fed to keep hiking rates even if the yield curve were to invert.
With this economy, what prompts the Fed to react to an inverted yield curve? A clear and convincing threat like that posed by the Asian Financial Crisis. If the inversion results from a sharp drop in long yields driven by such a substantial financial market disruption, the Fed will likely react.
But absent a financial market disruption, the Fed may rely on the argument that the yield curve is inverting at a low level of rates due to a low term premium and as such policy is not really as tight as it may seem. In other words, nothing to see here, folks.
Bottom Line: It may indeed be true that this time is different. Still, given the yield curve’s track record in past cycles, the Fed ignoring an inverted curve at the 10-2 horizon and pushing ahead with rate hikes would put me on recession watch. That recession though would still likely not emerge until another year or more passed after the inversion.
The big news from Federal Reserve Chairman Jerome Powell last week was not so much that he still sees the need for further interest-rate increases despite signs of trouble in the global economy. Rather, the surprise was that he doesn’t believe the U.S. economy is poised to overheat. The takeaway for markets is that there is no impediment to the Fed shifting to a more dovish stance should the economy stumble.
Headlines blared the latest recession warning today, this time from David Rosenberg of Gluskin Sheff & Associates. The culprit will be the Fed:
“Cycles die, and you know how they die?” Rosenberg told the Inside ETFs Canada conference in Montreal on Thursday. “Because the Fed puts a bullet in its forehead.”
I get this. I buy the story that the Fed is likely to have a large role in causing the next recession. Either via overtightening or failing to loosen quickly enough in response to a negative shock.
And I truly get the frustration of being a business cycle economist in the midst of what will almost certainly be a record-breaking expansion. Imagine a business cycle economist going year after year without a recession to ride. It’s like Tinkerbell without her wings.
But the timeline here is wrong. And timing is everything when it comes to the recession call. Recessions don’t happen out of thin air. Data starts shifting ahead of a recession. Manufacturing activity sags. Housing starts tumble. Jobless claims start rising. You know the drill, and we are seeing any of it yet.
For a recession to start in the next twelve months, the data has to make a hard turn now. Maybe yesterday. And you would have to believe that turn would be happening in the midst of a substantial fiscal stimulus adding a tailwind to the economy through 2019. I just don’t see it happening.
As far as the Fed is concerned, I don’t think we are seeing evidence that policy is too tight. The flattening yield curve indicates policy is getting tighter, to be sure. But as far as recession calls are concerned, it’s inversion or nothing. And even inversion alone will not definitively do the trick. I think that if the Fed continues to hike rates or sends strong signals of future rate hikes after the yield curve inverts, then you go on recession watch.
With inflation still tame, however, the Fed may very well flatten the yield curve with two more hikes and then take a step back. To be sure, it will be hard to stand down or even reverse course on the yield curve alone. After all, the yield curve is a long leading indicator. It will be the outlying data. But there is a reasonable chance the Fed will not tempt fate in the absence of a very real inflationary threat.
Let’s say for the sake of argument that I am wrong and the Fed inverts the yield curve in December of this year, keeps hiking, and doesn’t try to reverse course until it is obviously too late. Furthermore, assume the inverted yield curve foreshadows a recession like in past cycles. That means at least a year and maybe two before a recession actually hits. So the minimum timeline to recession is 18 months, even if everything goes right (or is it wrong?).
Also, we really shouldn’t discount the possibility that the Fed pauses even before a yield curve inversion. A market disruption from a trade war or external financial crisis that threatens to spill over into Main Street could put the Fed back on the defensive. So the whole story that the Fed will soon kill this expansion is a bit premature.
Bottom Line: The business cycle is not dead. The future holds another recession. But many, many things have to start going wrong in fairly short order to bring about a recession in the next twelve months. It would probably have to be an extraordinary set of events outside of the typical business cycle dynamics. A much better bet is to expect this expansion will be a record breaker.
Quick update on the data. First, the retail sales report reveals that the consumer rebounded solidly from a first quarter slowdown:Never, never, never underestimate the U.S. consumer’s willingness to spend! As long as they have the means to spend, they will do so. And today’s weekly read on the labor market doesn’t provide any hints this will be a problem anytime soon:
With the job market still chugging away like the Energizer Bunny, consumers will continue to have the means to support spending. In the meantime, CPI firmed in May but isn’t setting off alarm bells as core inflation remains low, easing back from a jump earlier in the year:
Interestingly, shelter inflation re-accelerated in the past few months, which is something to keep an eye on:
Altogether, no reason to think the Fed will pause at the September meeting. Baseline is that they keeping grind away with 25 basis point hikes each quarter.
Finally, shameless self-promotion:
The Federal Open Market Committee (FOMC) completed their June meeting with a 25 basis point rate hike, bringing the target range for the federal funds rate to 1.75-2.0 percent. The accompanying Summary of Economic Projections (SEP) revealed a modestly more optimistic outlook, as expected. The improving outlook prompted an upward revision to rate hike expectations with the median policymaker anticipating four rate hikes this year, up from three in March. The Fed dropped the explicit forward guidance language in the statement as they work to encourage market participants to undertake a more nuanced, data-driven approach to assessing the future path of rate hikes.
With the economy chugging along at a respectable clip that could exceed 4 percent in the second quarter, the Federal Reserve upgraded its assessment of growth from “moderate” to “solid.” Expected growth for 2018 as a whole rose from 2.7 to 2.8 percent while the unemployment forecast fell from 3.8 percent to 3.6 percent. If history is any guide, that forecast remains too pessimistic given the expected pace of growth this year.
The longer run estimate for unemployment held at 4.5 percent, but the upper end of the central tendency dipped from 4.7 to 4.6 percent. Assuming no significant uptick of inflation, I expect the longer-run unemployment estimate to fall if the actual unemployment falls faster than the Fed expects.
Inflation projections edged up for 2018, but expectations for core-inflation for 2019 and 2020 remained unchanged at 2.1 percent. Essentially, the forecasts imply that a slight bump in the expected pace of rate hikes from three to four rate hikes this year is sufficient to contain the inflationary implications of the modestly better economic forecasts.
To be sure, the Fed’s expectation that they will deliver a full four rate hikes this year should not come as a surprise. Indeed, I would argue that the two low dots in the March SEP were effectively irrelevant for the likely path of policy and eliminating those dots would shift the median projection to four rate hikes. In other words, the median policy maker was already so close to four hikes for 2018 that the bar to making it official this month was very, very low.
The median policy maker anticipates another three rate hikes in 2019. Policy makers also expect they will still raise rates to an above neutral 3.4 percent in 2020 while the longer-run neutral rate held at 2.9 percent. Any “hawkishness” in this SEP reflects the slight acceleration in the pace of hikes; the end game, however, remains unchanged.
The Fed continues to describe policy as accommodative, but dropped language indicating that policy would “remain, for some time,” accommodative. This needed to change given that the lowest estimate of neutral sits at just 2.3 percent, the Fed could be pretty close to neutral with just one more hike. Eventually too they will drop the description of policy as accommodative as rates move closer to the median estimate of neutral.
As policy edges closer to neutral, the exact timing of future rates hikes will become more data dependent. That said, make no mistake that the Fed continues to signal that rates will continue to rise at a pace of roughly 25 basis points per quarter given the expected pace of growth. I would not underestimate the Fed’s resolve in this matter. I expect this pace to hold for the next four quarters if the Fed’s forecast continues to be realized.
Bottom Line: Pay attention to the interplay of the rate and economic forecasts and the flow of data. The pace of data will almost certainly not slow sufficiently to prevent the Fed from hiking in September and probably December. I would say September is essentially a lock at this point. I also think you need to pencil in rate hikes in March and June of 2019. Recognize though that by mid-2019 the data might reflect the lagged impact of past tightening and the yield curve is likely to be fairly flat; both factors would slow the pace of rate hikes. The Fed will face a more difficult choice if the data holds strong while the yield curve inverts.
The U.S. economy is charging through the second quarter at a growth rate that currently looks to be faster than 3 percent, and I have argued that an interest-rate increase by the Federal Reserve this week and in September are basically a lock. What could go wrong with this forecast? Plenty.
Central bankers are set to hike interest rates at this week’s meeting of the Federal Open Market Committee (FOMC), an outcome widely expected by market participants and thus should come as no surprise. The economic projections will probably look a little stronger relative to January. I don’t anticipate large changes to the interest rate projections for 2019 and 2020; the general story that the Fed expects rates to rise above neutral will still hold. The 2018 median projection will likely rise to reflect a full four rate hikes this year (that only takes the shift of a single dot).
Attention will fall heavily on changes in the accompanying policy statement given expectations that the Fed will try to reduce market reliance on forward guidance in the statement and at least by default raise the importance of the forecasts. This shift risks creating more uncertainty about policy than the Fed intends because unlike the statement, the forecasts do not represent a consensus view of policy. Be prepared for more noise as policy makers may more often stake out public positions that appear at odds with those of key policymakers. To navigate the noise, focus additional attention on the statements of permanent FOMC voting members.
The minutes of the May FOMC meeting first hinted of a change in the statement the Fed issues to explain its policy decisions. The descriptions of the policy rate as “accommodative” and“likely to remain, for some time, below levels that are expected to prevail in the longer run” will soon be no longer valid. With just two more rate hikes, in June and likely September, policy rates will be at the low end of the estimate range of neutral policy. This near-term path of policy is thus at odds with the current language.
Moreover, as I explained here, the Fed will turn off the autopilot – the expectations of gradual, once a quarter, 25 basis point hikes – by the end of this year. Once policy rates are in the neutral range, central bankers recognize policy will be increasingly dependent on the expected path of the economy. It is thus more difficult to make promises of future policy.
Any headlines that interpret the changes as an end to forward guidance would be overstatements. The Fed will be changing the language of the statement to match reality. They won’t be abandoning forward guidance entirely. For example, they will retain the “dot plot” of monetary policy expectations. This means that while central bankers reduce the forward guidance provided in the statement, they will by either default or intention increase the importance of the forward guidance provided by the Summary of Economic Projections (SEP). The SEP informs on the Fed’s reaction function, or how its policy approach will change in response to evolving economic data. Via Reuters, here is incoming New York Federal Reserve President John Williams on the communication shift:
“…I think we just need to frame that where the economy is and how we are thinking about policy going forward a little bit differently. And when I say a little bit differently I mean less forward guidance in the language, less language about where we see policy moving, not necessarily no language about it, but less language about it. And more, I think, just trying to express as effectively as possible our views on the economic outlook, how policy fits into that economic outlook, and then use the quarterly economic projections, along with obviously the dot plots, to help put some numbers and some facts and figures that kind of fit in with those statements….
“What we should be explaining to people as much as we can is our reaction function, helping people to understand how monetary policy responds to the changing economic outlook in the context of our dual mandate goals. Trying to put that into words… sometimes just is hard to do and not that effective.
This shift in emphasis will increase the uncertainty surrounding the path of future rate hikes. Partly this is a feature, not a bug. It simply reflects the reality that policy makers will be less sure of the path of rates after reaching a neural policy stance. The risk for financial market participants is that this shift in emphasis raises uncertainty not only from the economic outlook but also from the “cacophony of voices” problem as policy makers take public positions on the path of rates that appear at odds with each other.
The problem of relying more heavily on the SEP is that unlike the statement, the economic projections do not represent the consensus of central bankers. Each policy maker provides an independent forecast. We have become accustomed to using the median of the SEP forecasts as a proxy for the consensus view of the FOMC, but this is not accurate as no such consensus view exists.
I suspect we are going to see policymakers attempt to both raise the importance of the forecasts as Williams does above while at the same time downplaying the relevance of the dots. That’s a recipe for policy confusion. More look at this, but don’t really look at this. In addition, policy makers will further aggravate the confusion because they also find the median forecasts useful as a baseline. For example, see Federal Reserve Governor Lael Brainard here.
Bottom Line: The Fed is set to hike rates this week and change the communication strategy. To navigate this change, first recognize that altering the current forward guidance in the statement does not mean the Fed is shifting to a more hawkish stance as it by itself shouldn’t impact the expected path of rates. Any shift in the path of rates will be driven by the data. It will increase the uncertainty of the timing of future policy changes. Assessing the path of policy will become more difficult especially because the Fed lacks an official consensus outlook for the economy and interest rates. Beware the cacophony of Fed speak. There will be risk of confirmation bias as it will be easy to find a policy maker whose views conform to your own. Instead, watch carefully how incoming data is shaping the opinions of permanent FOMC voting members as they are people that will be driving policy outcomes.