The way to think of a flattening yield curve is as a signal that the market expects Fed tightening to precipitate a slowdown that halts or even reverses future hikes. It’s the market’s way of saying they expect the Fed to tighten and then to stop tightening when weak data are released that result from the Fed’s tightening.
As you know by now, the way I think of Fed hikes is different than most people. I think of them as adding to interest income and pulling forward credit demand in the initial tightening phase. And that actually accelerates growth at first.
Only later, when the increase creates distress for marginal borrowers does the rate hike train actually ‘tighten’. Right now, we are in the accelerant phase of tightening. And I am expecting this to move to weakness in 2019.
But now we are also seeing a market signal of a coming Fed pause in the Treasury futures market as evidenced by this chart (click on the Twitter pic link to see the chart):
The market basically sees the Fed hiking cycle as over. Chart shows 2-year rates (blue) and accompanying 2-year 2-year forward rates (red). The two lines are on top of each other, much as in 2006. Market is putting a large weight on recession risk, little weight on Fed “dots.” pic.twitter.com/vWZmRC1VBT
— Robin Brooks (@RobinBrooksIIF) July 31, 2018
What the march higher in 2-year rates meeting 2-year 2-year forward rates says is that the market expects the Fed to be on hold within 2 years’ time. Basically, 2-year rates today are as high as they will be in two years’ time. And I think it’s right to read the closing of the gap between these charts as making this year mirror the tail end of the cycle from last decade. I would put 2018 as more akin to 2005 than 2006 though.
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