US curve flattening as Fed doves grow more hawkish

By Edward Harrison On Apr 17, 2018

This is today’s links post. The one link I want to highlight is the one on Neel Kashkari from the Wall Street Journal. The Minneapolis Fed President is considered a dove for having dissented on rate hikes under Yellen. However, after the Trump stimulus, he has become more hawkish and supports the Powell regime shift.

Kashkari joins Brainard, turns Hawkish

Here’s the part I would highlight:

Mr. Kashkari had been outspoken last year against rate increases because of concerns they would hobble the economic expansion in the face of subdued inflation.

Congress and the White House approved tax cuts last December and federal spending increases in February that are “macroeconomically significant, and they are big enough to have an effect on the trajectory of the economy…that could change things in a meaningful way,” Mr. Kashkari said in an interview at the Minneapolis Fed’s headquarters Thursday.

Mr. Kashkari voted against all three rate increases approved by the Fed last year during his first turn as a voting member of the central bank’s rate-setting committee. He had warned as recently as December the Fed’s rate increases could crimp the economic expansion.

“I was much more skeptical of whether we were on track to hitting 2% over the medium term,” he said in last week’s interview. “It now seems much more likely that we are going to actually achieve our inflation target in the near future, which would be a good thing.”

Kashkari sounds a lot like Fed Governor Lael Brainard, whose commentary I have been highlighting for weeks. It was her speech in early March that made clear a regime shift at the Fed was at hand.

The curve flattening continues

The question now goes to what impact this will have on the US economy. Since Fed policy acts primarily through the credit channel and its derivative interest income, look at rates. For example, here is a chart of the 2-year yield.

Source: Financial Times

The 2-year Treasury yield represents a sort of near-to-medium term outlook. It incorporates market expectations for Fed rate policy over the next two years. As such, it is widely considered a good gauge of market expectations regarding future Fed policy. Think of the 2-year as the consensus market take on the Fed’s dot plot of forward guidance.

On Monday, two-year yields made it as high as 2.386%. That’s the highest since the financial crisis a decade ago. Today the yield sits at 2.39%. And that’s up from 2.32% a week ago. So the market is telling us it expects overnight interest rates to rise over the coming two years.

Meanwhile, the benchmark 10-year Treasury yield is 2.84%. That’s lower than the level that triggered the equity selloff in February. And it’s lower than the 2.87% registered a week ago. So it says that all of the Fed forward guidance is transmitting to the front end of the yield curve. And so far none of it is going into longer-term yields. The question is why.

Think of curve flattening as a signal of tightening

The 10-year Treasury yield is a long-term market-determined rate. The Fed has much less influence on it because of the uncertainty about the economy and Fed policy over the long term. And so, we should think about this rate as a bellwether of economic projections for the economy.

The 10-year encapsulates the market’s view about inflation, about the appropriate level for real interest rates. And it encapsulates the market’s demand for safe assets via the term premium. What a flattening yield curve says is that the market doesn’t see the economy powering forward enough to allow the projected rise in near-to-medium term overnight rates to continue. It says that the Fed’s rate hike campaign will have to pause at some point down the line. It’s a sign of tightening.

Now, that’s not a terrible thing. The spread between the 2-year and 10-year bond is 45 basis points. And that’s a level we have seen during long stretches of expansion.

For example, look at the 1990s. The curve was this flat for the entire period from 1995 to 1999, when equities performed their best and as the unemployment rate hit multi-decade lows.

Flattening is not inversion

Economists surveyed by the Wall Street Journal say that the chance of a recession in the next 12 months is about 15%. My own baseline view is still for expansion throughout 2018 and almost all of 2019. Recession is more of a 2020 fear at this point.

Now, if the curve were to invert, that’s when the market would be sending a recession signal. We are 45 basis points away from that. The fear, then, is two-fold. First, the Fed transmits all of its tightening to the front end of the curve. That means any future rate hikes cause more curve flattening. And that brings us closer to a recession signal.

The second fear has to be that the Fed would disregard that signal. Some Fed officials have said curve flattening is not a definitive market signal. And so, the Fed might just continue to raise rates even if the curve were inverted.

At this juncture, I think the possibility of the Fed causing the curve to invert is real. And at that point, we will have 12-18 months at most to see what happens economically.

Here are the links.

Links