Yellen: The relationship between the slope of the yield curve and the business cycle may have changed

Markets are pricing in less than two rate hikes for 2018 in the aftermath of yesterday’s FOMC rate decision and press conference. Yet, the biggest takeaway from Chair Yellen’s press conference was her belief that there are “good reasons to think the relationship between the slope of the yield curve and the business cycle may have changed.” To me, this suggests that Fed officials MAY be inclined to disregard a flattening yield curve as a market signal and hike more aggressively. Some thoughts below

You know my baseline view here: I think the economy is doing well and we could even hit 3% year-on-year growth after Q1 2018 figures are released. The flattening yield curve doesn’t worry me yet because shallow isn’t the same thing as flat and flat isn’t inverted. But I lean more toward St. Louis Fed President Jim Bullard’s view than I do outgoing Fed Chair Yellen’s. Earlier in the month, Bullard was quoted in Bloomberg saying, “there is a material risk of yield curve inversion over the forecast horizon if the FOMC continues on its present course of increases in the policy rate.” The quote continues with him warning, “yield curve inversion is a naturally bearish signal for the economy. This deserves market and policy maker attention.’’

I think Bullard is exactly right. If the economy proceeds as I believe it will we will get 3 rate hikes in 2018, maybe even 4 — not the two currently priced in. And this is because the Fed has shown in its forecasts released yesterday that the unemployment rate is already below the so-called the non-accelerating inflation rate of unemployment. Now, NAIRU is a made-up target that doesn’t have much credibility with me. But it does drive many Fed economists’ thinking about how to deal with the Feds dual mandate. And with the Fed forecasting unemployment falling from 4.1% to 3.9% by year end, when its stated NAIRU is 4.6%, you’ve got the makings of 3 or 4 rate hikes next year.

Notice how projections from the December meeting show unemployment lower than they did in September. And this is happening against a backdrop of higher projected growth right through 2020. You don’t need to look at anything else to know that the Fed’s projections are bearish for two-year bonds.

And then, you have to ask yourself what happens to the curve slope if we get multiple rate hikes. I think it flattens and yesterday I projected we could see a further 35 basis points of flattening in the next six months.

And this is where Yellen’s statement comes into play. Now Bullard is saying that the yield curve will almost assuredly flatten if the economy proceeds as the Fed expects and that this flattening should be seen as a warning sign for the Fed. Yellen is stressing something totally different. She’s saying, in effect, “this time is different” – that a flat yield curve may not mean today what it meant in the past. I believe this is very dangerous thinking because we’ve been here before.

“I would not interpret the currently very flat yield curve as indicating a significant economic slowdown to come, for several reasons”

Ben Bernanke, 2006

The way I read Yellen today is the way I read Bernanke in 2006 – as saying in effect, we are going to hike rates irrespective of how flat the yield curve gets. Is this how incoming Chair Jay Powell sees things? If so, the market is going to be very surprised and short-dated Treasuries are not going to be where you want to overweight. And let’s remember, Bernanke ultimately proved wrong on this one because we soon had a downturn, just as the yield curve was signalling we would.

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