Friday, July 5, 2019

June 2019 Yield Curve Update

Rates have continued to dip.  Forward markets have already moved much of the way back toward zero.  This has been somewhat surprising to me.  I expected the Fed to maintain the Fed Funds rate at a plateau level, as they did in the last two cyclical reversals.  But they are almost certain to start to lower the target rate this month, and that is great news.

There is still some potential for trading gains in forward rate markets, I think, because short rates are highly likely to return to near zero.  I hope the newly dovish turn by the Fed is enough to give that move some oomph.  I think an important signal will be the long end of the curve.  If it remains low as the Fed lowers the target rate, this is a sign that the Fed is following the neutral rate down, and isn't really inducing nominal growth.  It will be a bullish sign if the long end of the curve moves up.

In fact, using the adjustment I make to the yield curve, at today's levels, the 10 year treasury yield would still be effectively near inverted rates even if the Fed lowers the target rate to zero.  My worry is that mistaken associations between low rates and loose money will prevent the Fed from being aggressive enough.  But, recent Fed communications have been more promising.

The first graph here shows the 10 year rate vs. the Fed Funds rate, and shows my modeled inversion indicator.  By this measure, the curve has been inverted for many months and moved much farther into inversion territory this month.  In some ways, that is a good sign, because it reflects expectations of near-term Fed rate cuts.  But, ideally, it would be better if long term rates held firm.  The fact that long term rates are declining along with short term expectations is a sign that frictions in credit markets were keeping long term rates high.  To me, this is the best way to think about yield curve inversion.  Some set of frictions in the market prevent long term yields from declining to unbiased forecasts of future short term rates when the yield curve is inverted.  I suspect that this causes problems with credit allocation that may be a causal element in the contractions that tend to follow inversions.  If long term rates decline when short term rates are lowered, that suggests that lowering rates has removed those frictions and allowed long term rates to move to a less biased level.  So, the good news is that Fed dovishness is helping to offer relief to markets, but the bad news is that this means an inversion is in effect and that usually leads to a contraction.

The market is currently priced to expect the dots on my scatterplot to move sharply to the left as short term rates are lowered.  But, the key to avoiding a recession is for the upcoming dots to also move up.  If they don't, then I suspect that we will be playing catch-up and economic growth expectations will remain subdued, which will continue to lead capital to safer assets instead of into riskier investments that can trigger productivity and employment strength.  It is hard to tell in real time, but it is beginning to look like real GDP growth peaked a year ago and that the 4 quarter real GDP growth rate will move back down below 3%.  One might expect real growth to level off as unemployment bottoms, but employment growth has been pretty stable since 2012 at 1.5% to 2%, and continues to move in that range as workers re-enter the labor force, so changes in employment growth don't point to a GDP slowdown yet.

The best thing that could happen is the Fed lowers the target rate aggressively, long term rates rise with new real growth and inflation expectations, and then FOMC members and pundits who incorrectly view lower rates as a stimulus to risky investments will interpret higher rates as less stimulative, and they won't pressure the Fed to stop lowering the target rate.

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