Will they or won’t they? With the U.S. yield curve flattening to new cyclelows, whether or not the Federal Reserve will stick to its plannedrate-hike path is a key question – and could soon become the keyquestion – for financial markets.
It is well-known that an inverted yield curve, as measured by the spreadbetween 3-month Libor and 10-year Treasury interest rates, has been a reliableleading indicator of recessions over the past 50 years. To be sure, the3-month Libor to 10-year spread is still positive at around 50 basis points currently.However, unless 10-year yields rise, the curve could invert by year-end ifthe Fed hikes rates another two times, as suggested by its own dot plot. Sowill Fed officials ignore a potential curve inversion and keep raisingshort rates beyond that point, or will they pause and adjust their forwardguidance to avoid a lasting inversion?
The Fed’s semi-annualMonetary Policy Report to Congress issued on 13 July remained silent on this question. However, itrepeated the language that Fed watchers can recite while sleeping:“The FOMC expects that further gradual increases in the target rangefor the federal funds rate will be consistent with a sustainedexpansion of economic activity, strong labor market conditions, andinflation near the Committee’s symmetric 2 percent objective over themedium term.”
So how many “further gradual increases” should we expect? A reasonableassumption would seem to be that, provided the economic backdrop citedabove doesn’t change radically, the Fed will raise rates until the fedfunds rate reaches the neutral rate, defined as a level of rates that keepsthe economy growing on trend and inflation on target over the medium term.OK, sounds good in theory, you may say, but where is neutral?
We at PIMCO have long argued that what we callThe New Neutral is somewhere between 0% and 1% for the real fed funds rate, whichtranslates to a 2%–3% nominal rate if inflation is at the 2% target.Conveniently, a useful new table in the Fed’s latest Monetary Policy Reportthat lists econometric estimates of the neutral real rate from sevenstudies, mostly by Fed economists, confirms just that. The seven pointestimates of the neutral rate range from 0.1% to 1.8%, with a median of0.7%. Assuming 2% inflation, this is very close to Federal Open MarketCommittee (FOMC) participants’ 2.9% median estimate of the so-called longrun fed funds rate in theJune Summary of Economic Projections (SEP).
Yet, if the Fed would go to neutral as defined above, and if the 10-yearyield were to stay where it is currently, the curve would likely invert,sending a recession signal. So again, how would the Fed react to aninversion of the curve?
At this stage, only a few participants (among them regional Fed presidentsRaphael Bostic, James Bullard, Patrick Harker and Neel Kashkari) appear tohave made up their minds and have expressed serious concerns about apotential curve inversion. Others seem more open to the argument that “thistime may be different”: With a low or even negative term premium depressinglonger-term interest rates, a flat or inverted yield curve may not signal arecession this time, as the economy largely depends on intermediate tolong-term interest rates (which are very low) – or so the story goes.
I’m not convinced, for two reasons. First, Fed officials made similararguments when the curve inverted in the last cycle, before the globalfinancial crisis and Great Recession. At the time, they argued that curveflatness or inversion could be ignored because a global savings glut keptlong rates low as the Fed hiked rates above neutral. That didn’t end well.
Second, when short rates rise above long rates for whatever reason, bankswill be less able or willing to engage in maturity transformation andcredit creation. In fact, work by our U.S. economist, Tiffany Wilding,shows that the shape of the yield curve, with a two-year lead, has been agood predictor of the credit impulse – the change in the growth rate ofbank loans – which in turn correlates highly with real GDP growth.
Yielding to an inverted curve
While the jury on curve inversion is still out, here’s my prediction:Should the yield curve (defined as the 3-month Libor to 10-year Treasury spread) invert, Iwould expect the Powell Fed to change gears and signal a pause in thehiking cycle to avoid a lasting curve inversion. This decision would likelybe helped by an adverse reaction of risk assets to curve inversion and arelated tightening of financial conditions. More curve flattening in thenear term appears likely, as trade tensions look set to intensify further,thus weighing on longer-term yields as the Fed keeps marching up the dotplot; however, I don’t expect a lasting inversion, as the yield curve willlikely become part of the Fed’s reaction function once it inverts.
But what if I’m wrong, and the Fed allows the curve to invert in the beliefthat this time is different? In this case, I’d be even more convinced thatwe’ll enterthe next recession as early as 2020 – which of course would likely be the mother of all curvesteepeners yet again.
For more of our views on interest rates, see PIMCO’s Rise Above Rising Rates page.
Joachim Felsis PIMCO’s global economic advisor and a regular contributor to thePIMCO Blog.