Bond Markets: Yield Curve Inversion?

We do not believe current economic conditions warrant a Fed policy which is so restrictive it might create an inverted yield curve. Unfortunately, the Fed has a history of tightening credit conditions until something breaks. We would like to believe this time will be different. 

Yield Curve Flattening

The chart beside shows the spread between the 5 and 10-year UST compared to the Fed Funds rate. This spread is one measure of how the yield curve has flattened since the Funds rate hit the zero bound and began to rise. We expect this trend to continue until the Fed has finished tightening.

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Yield Curve Inversion

Recently there has been chatter about a possible yield curve inversion in the U.S. Treasury market. This is an interesting development considering the Fed has been falling short of its 2.0% inflation target and the economy has been growing below trend. 

The chart below shows the yield on the 90-day T-Bill (1.84%) compared to the yield of the 10-year UST (3.03%). This spread is about 119 bp’s.

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Market pundits have been calling for the Fed to raise the Fed Funds rate from 1.75% to as high as 2.50-2.75% by early next year and this has created fears of a yield curve inversion. An inversion occurs when short-term rates are higher than long-term rates. 

There are some problems with this scenario: 

1. Fed moves are data dependent and we will have to see what inflation and the economy do through the end of the year. If the economy slows and inflation remains well-anchored it will be difficult for the Fed to justify several rate increases. 

2. The Fed should want to keep the yield curve positive. The Fed is engaging in Quantitative Tightening (QT) to reduce the size of its balance sheet at the same time it is increasing the Funds rate. The Fed could move more quickly to shrink its balance sheet which would put pressure on the long end of the market, or it could move more slowly to hike the Fed Funds rate. The Congressional Budget Office is forecasting budget shortfalls of about $1 trillion a year for the next few years. The combination of increased supply of UST to finance the deficits and the shrinking of the balance sheet by the Fed should put upward pressure on long-term rates. However, it is possible that long rates will stay low if inflation fails to increase and the economy does not respond well to the tax cuts. 

If long rates stay low and the Fed continues to increase the overnight Funds rate, the yield curve could invert.  This tends to be a precursor of a period of economic weakness. We have a model which shows the increased probability of recession based on the size of the yield curve inversion. The last two recessions witnessed this phenomenon before the economy weakened. Currently the probability of a recession occurring based on our model is only 1.0% since the yield curve is still positive.

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If the Fed did cause an inversion in the yield curve, we would become more negative on the economy and more positive on the rates markets.