Look no further than the $15 trillion US government bond market for evidence investors are not convinced the Federal Reserve can keep raising interest rates at the recent clip without derailing the economy, which remains fragile despite strong headline numbers.
- The flat yield curve suggests investors are not as convinced as Federal Reserve officials about their ability to continue raising interest rates without harming the economy.
- Steve Blitz of TS Lombard says what really matters for bank lending is the gap between the federal funds rate and the two-year note, which has been widening.
- St. Louis Fed's Bullard: "What we could do is take signals from financial markets that are telling us that we're about where we need to be right now."
Look no further than the $15 trillion US government bond market for evidence investors are not convinced the Federal Reserve can keep raising interest rates at the recent clip without derailing the economy,
The Fed is widely expected to raise the official federal funds rate by another quarter percentage point later this month, bringing its ceiling to 2.25%. It has been raising rates predictably by a quarter percentage point every three months, when Fed Chair Jerome Powell holds his post-meeting press conferences.
Yet the ongoing compression of long- and short-term Treasury bond yields, known as a yield curve flattening, is not only a traditionally-reliable harbinger of recessions, but also arguably a contributor to economic downturns.
"Talk of the flatter yield curve presaging recession continues to run rampant among the chattering classes,” Steve Blitz, chief US economist at TS Lombard, wrote in a research note.
And it’s not just the more closely-watched yield gaps, like the spread between 10- and two-year notes.
What counts is not whether the curve is flat but whether it’s negative, and the negative curve that counts most is the spread between the yield on two-year Treasury notes and the federal funds rate, Blitz writes.
"We have long made the point that the shape of the curve is not a talisman. It works because when short-term money earns more than lending, the flow of loanable funds moves away from credit."
The chart below shows that when the two-year Treasury note starts to yield less than the funds rate, "banks begin to tighten credit standards for commercial loans to mid-sized and large firms (identified by the circled areas). Not surprisingly, recession begins soon after."
That particular curve has actually been steepening since last summer, says Blitz, and the percentage of banks tightening credit standards has shrunk in line with historical norms.
James Bullard, president of the St. Louis Fed, thinks the central bank should heed the age-old message of the yield curve and hold back on further interest rate increases until further notice.
"We've already been preemptive," he told Fox Business this week, according to transcripts of the interview. "We raised rates while the inflation rate was below our target. We started shrinking the size of the balance sheet before inflation came up to target. So we've done these things over the last two years. Now we're in pretty good shape and I think what we could do is take signals from financial markets that are telling us that we're about where we need to be right now."
In particular, Bullard pointed to one thing: a "very flat" yield curve.
"I’d rather not see an inverted yield curve in the US That's usually a harbinger of a slowdown ahead. And inflation expectations, based on market based measures, are low and remain right around our target. I think it shows that we've got a pretty good policy right now and we should stay where we are and see how the data come in."