Which way are interest rates headed? After the Federal Reserve bumped up rates four times last year bond investors were prepared for further increases in 2019. The stock market didn’t like the news one bit and reacted with a fourth quarter drop of nearly 20%. Six months into 2019, the yield curve has shown a different story.
But the risk of further rate increases was virtually eliminated by the recent June meeting of the Federal Open Market Committee.
Nine of ten voting members cast in favor of keeping interest rates steady between 2.25% to 2.50%. Depending on how Fed Chairman Jerome Powell’s remarks are interpreted, there is even the possibility of a cut in rates before year end. But Powell also waffled on many key points.
So which way are interest rates headed? On the one hand, we have a robust U.S. economy that grew 3.2% in the first quarter of 2019 and averaging 3.0% for the last nine months. On the other side, bond yields tell a different story. For the first time in several years we are confronted with an inverted yield curve.
Yield Curve Inversion
On two occasions since 2016 the yield on the U.S. 10-Year Treasury Note has fallen below the 3-month yield. This is a classic sign that bond investors are fearful of an imminent recession and rush into the 10-Year Note in anticipation of the Fed cutting rates.
The current yield curve as of June 24, 2019, shows the 1-year note at 1.92%, which is greater than the 2-year, 3-year, 5-year, and 7-year treasury notes. However, the 10-year, 20-year, and 30-year treasuries continue to maintain a normal curve.
The question boils down to this…is a U.S. recession coming in the near future? There is little doubt that the longest running economic expansion in history will end at some time. The only question is when and is an inverted yield curve still a good predictive tool?
For our money, the yield curve has lost a chunk of its predictive power. Here is why. The theory behind the yield curve reflected the risk premium lenders demanded to compensate for inflation. In 1980, for example, U.S. inflation ran as high as 12%. Three month notes at one point were in excess of 20%.
Today, these same notes yield 2.13%. Meanwhile the 10-Year Note at the time of this writing was yielding 1.98%. Rather than signaling a recession, the compression of the 10-Year end of the curve signals change in investor fears from inflation to deflation.
An overlooked part of yesterday’s FOMC meeting was the statement that inflation was “running below” the Fed’s modest 2% objective. For the year, officials slashed their forecast to a range of 1.5%-1.8%.
A Dangerous Dilemma
So here is the dilemma facing the Fed. Never before has economic expansion been so strong for so long while inflation remains so muted. They must be concerned over what would happen to price levels if GDP growth dropped to 2% or less. Price deflation becomes a real possibility. The impact would be ugly.
For the U.S. with over $21 trillion in debt, sustained deflation would have dire consequences in terms of the true cost of debt repayment not to mention the effects on the ability to support economic growth. This is the most compelling argument for sustained low interest rates.
Article By: James Waggoner