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Economic Insights

What might the U.S. Federal Reserve’s policy pronouncements suggest for the yield curve—and the future direction of the U.S. economy?

 

In Brief

  • If faster economic growth drives the unemployment rate much lower, the Fed may have to tighten more aggressively.
  • The slope of the yield curve may well prove to be a less reliable guide to the timing of the next recession than it has been in the past.
  • We believe stocks will remain cheap relative to the 10-year Treasury bond until the 10-year yield rises to roughly 3.75%.

 

The Federal Open Market Committee (FOMC), the policy-making unit of the U.S. Federal Reserve (Fed), raised the benchmark fed funds rate by a quarter-percentage point, to a range of 1.75%–2% at its meeting on June 13, 2018.

The fed funds rate hike marked the seventh rate increase since December 2015 and the second rate hike this year.  That hike is “another sign that the U.S. economy is in good shape,” said Fed chairman Jerome Powell at a press conference following the meeting.

Powell went out of his way to reaffirm that the contraction of the Fed’s balance sheet (that is taking place to roll back quantitative easing) is independent of the interest-rate increases the FOMC has implemented in pursuit of its dual mandate: stable prices and maximum sustainable employment.

Notably, the statement released at the end of the meeting differed from the previous statement in one important respect: it removed reference to the likelihood that economic conditions were expected to evolve in such a way as to permit further gradual rate increases and that rates would still remain below levels expected to prevail in the long run.

Combined with references to a strong economy and a slightly steeper path of rate increases in the quarterly Summary Economic Projections, this implies that the Fed could raise rates somewhat more often than every three months and that the rate could eventually overshoot the 2.9% the Fed currently considers as consistent with its dual mandate in the long run.  (Powell also announced that he would henceforth hold a press conference after every FOMC meeting, as is already the custom at the European Central Bank, instead of every three months.)

The FOMC has acknowledged that if faster economic growth drives the unemployment rate much lower than the current level of 3.8%, it may have to tighten more aggressively. Implicit in this is that tighter monetary policy would be warranted if the recent fiscal stimulus drives employment above the maximum level consistent with an inflation rate of 2% in the long run.

If the Fed is right about the equilibrium interest rate being just below 3%, fiscal and monetary policy are both stimulating the economy to grow rapidly at the moment. In a very tight labor market, concurrent with inflation very close to the 2% target, we believe this clearly is inappropriate.  But in the current environment, Fed policymakers may well come under political pressure for raising rates too aggressively.

Yield Curve Inversion and Recession

Since the Fed started tightening monetary policy two and a half years ago, the cumulative increase of 1.75% in the fed funds rate has passed through almost one for one into the yield of the two-year Treasury note. About a third has passed through into the yield on a 10-year Treasury bond. Thus, the yield curve has flattened considerably, although it still has a positive slope of about 40 basis points (bps). If the pass-through of fed fund increases to longer-term yields holds, the yield curve will invert after three more 25 basis-point increases, or in early 2019.  (An inverted yield curve is the interest-rate environment in which long-term debt instruments have a lower yield than short-term debt instruments.)

Chart 1.  Inverted Yield Curve and Recessions: Will History Repeat?

Yield curve (10-year Treasury bond - Two-year Treasury note) yield differential

Source: Federal Reserve Bank of New York and Bloomberg.  For illustrative purposes only and does not represent any specific portfolio managed by Lord Abbett or any particular investment. Past performance is not a reliable indicator of future results.

The yield curve has inverted before every recession going back to the 1960s, although just barely in the last two cases. Inversion historically has  set in about a year before a downturn starts, because the market anticipates falling short-term rates long before the economy gets weak enough for the Fed to start cutting.

But the lag may be longer this time around, and the inversion much steeper.  A deeply negative term premium (i.e., the excess yield that investors require to commit to holding a long-term bond instead of shorter-term bonds) may be causing the yield on the 10-year Treasury bond to be unusually low compared to the two-year Treasury note, thus distorting the relationship between the current yield and future short-rate expectations.

Thus, investors may not be as pessimistic about future economic growth as suggested by a flattish yield curve. If current conditions hold, the slope of the yield curve may well prove to be a less reliable guide to the timing of the next recession than it has been in the past and the magnitude of the inversion much greater before the downturn materializes.

Equity Valuations

Turning to equities, they are currently priced at a wider than normal risk premium. History back to the 1960s reveals an average equity risk premium (ERP) of about 4.1% (using the Aswath Damodaran model).  (ERP is the excess return that investing in the stock market provides over a risk-free rate.) Current consensus expectations for earnings growth and a long-term expectation of earnings growth in line with the bond yield imply a current ERP of just under 5%. Thus we believe stocks will remain cheap relative to the 10-year Treasury bond until the 10-year yield rises to roughly 3.75%.

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