Flattening Yield Curve Is Sending Message About Fed's Rate Plans
(Bloomberg View) -- The “flattening yield curve” is back. The story took a breather when longer-term interest rates jumped during the first quarter. A more turbulent stock market, however, has driven investors back into bonds, putting the flatter yield curve in the news again and raising ominous concerns about a looming recession. Those worries are so far unfounded, but they indicate the Federal Reserve is further along in the tightening cycle than its latest projections suggest.
The difference between short- and long-term bond yields curve could remain relatively narrow for years, as it did in the late 1990s, while the economy continues to grow. As a result, the resumption of flattening, which has shrunk the difference between two- and 10-year Treasury note yields to less than half a percent for the first time since 2007, should not raise concerns of imminent recession. It is an inverted curve -- when short-term interest rates exceed long-term ones -- that has foreshadowed previous U.S. recessions. Recent research by San Francisco Fed economists found that the curve still has predictive power. That suggests we should not ignore any inversion.
Although the curve is not predicting a recession, the flattening does provide useful information about the economy. For instance, the inability of the curve to shift higher after 10-year yields approached 3 percent in February suggests the U.S. has yet to experience a supply-side boost from either tax cuts or allowing the economy to run hot. In either case, long-term rates should have risen as faster productivity growth drove up neutral rates. Similarly, the continuing demand for Treasuries suggests inflation will remain muted and fears of a debt crisis from fiscal deficits are overblown.
In other words, the flatter curve indicates that the economy generally remains the same, with no game-changing developments. The economy is in the mature stage of the business cycle while the Fed continues to raise short-term policy rates to contain and cool economic activity, flattening the curve along the way.
The inability of 10-year yield to rise above 3 percent (similarly, the curve is largely pivoting on a 30-year yield of close to 3 percent) suggests that the Fed will be hard-pressed to raise short-term policy rates above that level without risking a downturn. At that point, policy makers will have tightened policy sufficiently to invert the yield curve. Absent a rapid policy reversal, that degree of tightening probably is consistent with recession.
The latest forecasts contained in the Fed’s Summary of Economic projections, however, indicate that the median policy maker anticipates the federal funds rate will rise to 3.4 percent, which is restrictive by the central bank’s own definition of a longer-run policy rate of 2.9 percent.
Altogether, the resumption of yield-curve flattening indicates that the Fed likely will not get to that 3.4 percent. At this point, the central bank expects this tightening cycle to last into 2020. Assuming there is no supply-side miracle and the current pace of tightening (three to four rate hikes a year) is sustained, the tightening cycle won’t last past the end of next year at the latest, at least not without putting the expansion at risk.
This column does not necessarily reflect the opinion of the editorial board or Bloomberg LP and its owners.
Tim Duy is a professor of practice and senior director of the Oregon Economic Forum at the University of Oregon and the author of Tim Duy's Fed Watch.
To contact the editor responsible for this story: Max Berley at mberley@bloomberg.net.
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