The Fed has inverted the yield curve

Back in September 2018, Fed Governor Lael Brainard dismissed yield curve inversion as a signal of recession, something I saw then – and still see now – as a mistake. And what I said then is that this mistake would lead to the Fed’s over-tightening, yield curve inversion and potentially recession. That’s where we are today – with 3 month yields higher than 10-year Treasury rates. So, let me update you on how we got there and what I think we could expect next.

Ignoring the data

First, back in September, I wrote a post, saying “This is why I told you in March to listen to Lael Brainard. She makes the intellectual case for inverting the yield curve“. That was the actual title of the post.

In March, speaking about Brainard, I wrote that “Now she is teeing up the latest regime shift. In a speech echoing Powell’s Congressional commentary, her next speech is entitled “Navigating Monetary Policy as Headwinds Shift to Tailwinds”…So clearly Powell’s Fed colleagues ‘signed off” on his remarks. And having Brainard, who is usually considered more dovish, give a talk on economic tailwinds speaks volumes. The speech title alone is hawkish. A regime shift is at hand.”

And, indeed we did see a shift. Not only did the Fed raise interest rates in 2018, it raised them four times instead of the three times its policy guidance at the beginning of the year had called for. And the Fed began shrinking its balance sheet at the same time, what I have called double-barreled tightening. And Brainard, a supposed dove, was onboard with this. That’s what a regime shift looks like.

The problem was this quote I highlighted in that September post:

Like many of you, I am attentive to the historical observation that inversions of the yield curve between the 3-month and 10-year Treasury rates have had a relatively reliable track record of preceding recessions in the United States.¹⁶ But unlike these historical episodes, today the current 10-year yield is very low at around 3 percent, which is well below the average of 6-1/4 percent during the decades before the crisis.

She was telling us: A. in the short-term, not only can the Fed raise rates rates above its so-called neutral rate, but B. that’s something it was considering doing. And the yield curve’s inverting wouldn’t put them off doing so. Basically, this time is different.

How this worked out

My view at the time:

We should take this as clear policy guidance. The Fed is now prepared to invert the yield curve in the expectation that doing so does not automatically mean that recession will follow. It is going to do so cognizant of the risks of doing so because of the historical record of inversion preceding recession. Brainard says by hiking at a gradual pace, the Fed can manage this process well.

My view: This is a big experiment. And the risks to the US and global economy are considerable. I am willing to entertain the possibility that curve inversion won’t lead to recession. But I am definitely concerned. And I believe the credit cycle will turn in 2019. And it’s at that point we will see whether Brainard is right not to worry.

This experiment has gone decidedly pear-shaped. Both the global and US economies have downshifted. In fact, the data say the downshift occurred even while the Federal Reserve was hiking rates. So, at the end of 2018, the Fed was hiking into weakness.

And now, 3 month yields are higher than 10-year yields. The yield curve has inverted. Put more bluntly, the Fed has inverted the yield curve. So, what does the Fed do now?

Well, when I first wrote about inversion back in November 2017, I titled the post “Why the flattening yield curve doesn’t worry me yet” because we still had 70 basis points of runway between 2-year and 10-year yields, the spread I was looking at as the recession indicator. And looking at the historical data, here’s how I interpreted it:

First, the steepness of the yield curve is not a sign of impending economic acceleration or deceleration per se. Rather, the curve is an indicator of the market’s perception of the level of monetary accommodation. For example, when the yield curve steepness peaked in December 2013 as the Fed ended QE3, the subsequent flattening was a sign that the market believed the Fed was becoming less accommodative, not necessarily that the economy was slowing.

Second, the yield curve has to invert to signal recession. Every time there has been a recession there has been an inversion beforehand. And because long-term interest rates are a series of future short-term rates, what an inverted yield curve is essentially saying is that on balance Treasury market participants believe that the Fed will be forced by a weakening economy to start cutting rates in the medium-term future in order to prevent the economy from becoming even worse. That’s why December 1994 was a near miss and June 1998 saw a brief inversion but no recession. In the case of 1994, the Fed was forced to cut and the economy actually recovered. In 1998, the Fed also cut and added liquidity to boot, even helping engineer a rescue of LTCM. The economy avoided recession again.

What to do

So inversion does not equal recession. The way it works is that flattening precedes inversion and inversion precedes recession. But inversion gives the Fed 12-18 months to react — or for past policy to feed through. That means that the Fed can still avoid a recession if they react with enough vigour and quickly enough to counteract the over-tightening they have already done.

That probably means the Fed will have to cut this year – just as the fed futures are showing the market expects the Fed to do. If the Fed doesn’t cut this year, the chances of a recession increase, and could potentially become a base case by the end of this year.

So Brainard was wrong. This time is not different. Just because the 10-year was at 3% in September doesn’t mean that an inversion of the curve has any less predictive power. What an inversion is saying is that the Fed is too tight relative to credit and financial conditions for it to maintain their policy rate over the medium term. Inversion means the Fed will be cutting in the not too distant future due to economic weakness. And when the Fed fails to understand this signal and raises rates anyway, it has only itself to blame if it leads to a recession.

It may not be too late still. But time is running out. The Fed’s dovish policy downshift on Wednesday was simply not enough.