Flat Yield Curve Is Just What the U.S. Economy Needs
(Bloomberg) -- The tight gap between short- and long-term U.S. government bond yields is keeping central bankers and market participants on the edge of their seats because it's typically believed to foreshadow an economic slowdown. But a look at the 1990s reveals that the economy can thrive even during long periods when the yield curve is very flat.
In the middle part of that decade, the Federal Reserve executed an almost perfect soft landing for the economy, aggressively raising interest rates 300 basis points over the course of 12 months beginning in February of 1994 and then cutting them by 75 basis points beginning in July 1995. The yield curve averaged just 35 basis points from 1995 through 1999, down from 140 basis points in the first half of the decade and compared with about 50 basis points currently.
If you sold or avoided equities during the late 1990s thinking that the yield curve was predicting weak growth, you were on the wrong side of the bet. Both the economy and stock market surged, with gross domestic product expanding by an average of 4.5 percent each quarter and the S&P 500 Index gaining 139 percent.
The lesson is that betting against the economy or stocks on the basis of a flat yield curve is a dangerous game. A sustained flat yield curve is most likely consistent with a period of economic stability as actual and expected policy rates hew toward longer-run neutral rates, which are deemed to be lower now than in the past. In other words, a combination of trend growth, stable inflation and low unemployment is a Goldilocks-like economy.
It is too early to say whether this time be the same as the late 1990s. We won’t really know until the Fed brings this tightening cycle to a close. Policy makers have raised rates five times since December 2015, boosting their target for the federal funds rate to a range of 1.50 percent to 1.75 percent from 0.25 percent, with at least two more quarter-point increases expected this year. The lack of an inversion of the yield curve, which is when short-term rates rise above long-term rates, indicates the Fed hasn’t tightened so much as to end the expansion. In fact, the economy looks solid as the expansion approaches its ninth year.
Still, equities may struggle given tighter monetary policy and concerns that high labor and resource costs will weigh on profit margins. Recall that in 1995 equities didn’t take off until the Fed brought the tightening cycle to an end without triggering a recession.
Moreover, maintaining a flat yield curve for an extended period of timing likely requires some deft monetary policy moves. The 1994-1995 soft landing wasn’t the last major action by the Fed in the decade. The yield curve briefly inverted in the middle of 1998 during the Asian financial crisis. The Fed, sensing the danger to the economy, subsequently cut rates by 75 basis points to help extend the expansion. The Fed’s magic wore off in 2000 as they resumed their rate increases even after the yield curve inverted. A recession followed the next year.
We can’t carry the 1990s analogy too far. Equity price gains of that magnitude seem unlikely barring another bubble like the dot-com one, and productivity growth today looks anemic compared to those driven by innovations in information technology. But the example of the 1990s provides clear evidence that today’s flat yield curve doesn’t necessarily indicate tough economic times ahead. It could easily be the opposite; perhaps an extended period of Goldilocks growth awaits.
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