The US yield curve and the next recession.

The current US  economic expansion started in July 2009 and is already  much longer than the post-war average, although still  below the 10-year record duration set in the 1990’s, while closing in on the no.2 spot, set at 106 months in the 1960’s. A near term downturn is not inevitable but history suggests is likely at some point over the next few years. Forecasters are  poor at predicting recessions, and so there is interest in other potential signals. Equity markets generally turn down ahead of the real economy but they can and do fall without that precipitating a decline in GDP, so there is a risk of a false signal. The relationship between short term interest rates and long rates  (the yield curve) is another indicator of note, and in the US has proven  remarkably accurate ahead of the last seven downturns. Specifically, a yield curve inversion ( 10 year yields below 2 year yields or as some prefer, 3- month rates) has proven to be an excellent signal of a US recession a year or so ahead.

Why the success as a signal? Longer term  bond yields  carry a risk premium and are therefore generally higher than short rates, and may also be influenced by specific demand/supply factors at different maturities. For example, banks generally buy shorter term bonds, while pension funds seek much longer maturities. Expectations about the path of short term rates over the period are the most important factor, however, which in the US amounts to expectations about the Fed’s monetary policy and inflation. If policy is tightened in response to a booming economy or above target inflation longer term rates tend to rise, albeit by less than the move in short rates (the curve flattens) and may eventually invert if the market believes that  short rates have peaked and will eventually start falling . The inverted yield curve may also help precipitate a downturn because it dampens margins for the banking sector (banks borrow short and lend long)

The US yield curve is not currently  inverted but it has flattened appreciably; the 2-10 year spread has fallen from a peak of 260 basis points in late 2013 to just under 60 now, having started the year at 135.The recent pace of flattening has prompted much market debate  particularly as short rates are still very low by historical standards.

The Fed is  widely forecast to raise short rates again as early as December , and has signalled that it expects to tighten further in 2018, yet  10-year yields have fallen in absolute terms over the past month and are well below the highs in yield recorded earlier in the year.Maturing Treasuries are no longer being fully reinvested and, all things equal, the Fed’s decision to steadily reduce its holdings of bonds might be expected to push yields up. Some argue that issuance is shifting towards  the shorter end of the yield curve, so supporting longer dated paper, which in any case is still in strong demand as a ‘safe’ asset and  such assets are relatively scarce as central banks elsewhere are still buying.

A bigger factor may simply be that the market is convinced, at least for now, that  US inflation will continue to disappoint the Fed and remain below the 2% target, so implying that short rates will not rise to the extent the FOMC expect. The current  core inflation rate is only 1.3% ( the consumption deflator ex food and energy)  and was last (briefly) above 2% in early 2012. Most Fed governors believe that inflation will eventually start to accelerate as wages belatedly respond to the extremely low unemployment rate, but that view is not universally shared. Indeed, the minutes from the most recent FOMC meeting point to growing doubts as to whether sub-target inflation is indeed ‘transitory’.

Yield curve models are currently giving a low probability of recession in 2018 it has to be said ( the New York Fed’s model indicates around 10%) but the yield curve certainly bears watching given the recent trend.

 

The Fed versus the Market

Central Banks set short term interest rates and can influence longer term rates  but the market is in control of the latter and determines financial conditions in general. At times, financial conditions can move in the opposite direction to the stance of monetary policy, and we have a good example of that playing out now in the US.

The Federal Reserve has tightened policy and has signalled  this process will continue; the Fed Funds rate target is currently 1% higher than it was eighteen months ago, following four rate increases,  and the FOMC expects conditions to evolve that will ‘ warrant gradual increases‘ over time. Furthermore, the Fed’s Balance sheet will start to shrink ‘relatively soon’, as the Central Bank stops reinvesting some of the bonds purchased under QE. Yet the market is currently giving a 60% probability to rates being unchanged by year end, and broader financial conditions are now looser than they were when the Fed started to tighten.

Indeed, financial conditions in the US have rarely been easier, according to The Chicago Fed’s Financial Conditions Index. This uses over 100 financial variables (including the exchange rate, equity market volatility, credit spreads and the yield curve) to derive a weekly snapshot of risk, liquidity and leverage in the US. It is clear that the Fed is therefore at odds with the market; the former believes it is time to tighen policy, albeit gradually, while the latter acts as if the economy does not need such medicine.Moreover, some FOMC members have voiced concern that loose financial conditions carry risks for financial stability and increase the chances of a sharp correction in asset prices.

Why is the market shrugging? Unemployment is very low and  is around what many think  of as full employment, but inflation remains stubbornly below the Fed’s 2% target, and has eased in recent months. The economy is growing but at a modest pace ( 0.9% over the first half of 2017) and the market may well believe that inflation will stay low for structural reasons, contrary to the Fed view of a gradual pick up to target.

Does this  divergence matter? After all, official rates may be higher but policy  remains accommodative  ( the real Fed Funds rate is still negative) and it may well be that financial conditions may indeed move if rates do rise steadily from here, as indicated by Fed projections. If not, the Fed may have to raise rates more aggressively if it wants to secure a tightening in financial conditions overall. An inflation shock would change things but for the moment at least  markets  simply do not believe that the Central Bank needs to tighten as much as the Fed itself thinks. One of them is wrong.

Fed Hard to Fathom

In December last year the US Federal Reserve tightened monetary policy, albeit by only a quarter point, citing the ‘considerable improvement in labour market conditions’ and an expectation that inflation would gradually recover to the desired 2% level. The accompanying statement emphasised that further rate increases would be gradual, although the projections released at the time from the 17 FOMC participants (the ‘dot plot’) indicated a median expectation  that 2016 would see four further quarter point rises.

The market was not convinced but the latest ‘dot plot’ , released in mid-March, was still a surprise to many, as the median expectation now showed only two rate increase by year-end. True, growth was now projected to be marginally weaker in 2016 and 2017 but the unemployment rate was also forecast to be  lower, falling to 4.5%, against  4.8% in the long run. Inflation ( the Fed’s measure is the personal consumption deflator)  was expected to end the year at 1.2%, down from the previous 1.6% forecast, but the core rate forecast  (defined as ex food and energy) was unchanged at 1.6%.

Monetary policy is deemed to have ‘long and variable lags’ so one might think that unemployment around the Fed’s desired level alongside an expectation that inflation will pick up would be consistent with steady rate increases. let alone a change to a more dovish rate outlook. Core inflation has actually  picked up of late , rising at an annual 2% rate over the past three months, and the annual rate is 1.7%, which is above the Fed’s expectation for the year-end. Yet Janet Yellen, in a recent speech, emphasised that low inflation expectations were now a concern. Survey measures had shown a fall while market based measures had also declined ; the 10-year break-even inflation rate fell to 1.2% in February. She highlighted the risk that lower expectations would feed into wage and price setting, so increasing the probability of inflation remaining below target for longer. The Fed Chair also flagged the possibility that  the unemployment rate could fall much further without triggering wage inflation and  also pointed to international risks to the US economy.

So it is now very difficult to see what would trigger a rate rise in the coming months. A further improvement in the labour market does not seem a sufficient condition and higher spot inflation may not be sufficient either, given the emphasis put on inflation expectations. In fact the latter is heavily influenced by spot inflation anyway, particularly high frequency purchases like fuel, and  market expectations have actually risen again of late, perhaps driven by the rebound in oil prices in March.  Crude prices have  fallen back again in the past week, however, and this may dampen expectations again.

The Fed funds future for December is trading at 0.5%, so the market is no longer convinced we will see any rate increase this year. Central banks generally tread a line between Discretion on policy or following a more Rules based approach and the former is driving the Fed at the moment, which makes for flexibility but makes it very hard to read their next move.

 

Press Conferences, the ECB and the Fed

The ECB and the Fed differ at many levels, including their respective mandates (the latter is charged with  maintaining full employment as well as price stability ) and the frequency of policy-setting meetings (one a month for the ECB but only eight a year for its US counterpart). The Fed’s Open Market Committee, which sets monetary policy, has twelve voting members and releases minutes of its deliberations, including the voting pattern, whereas the ECB Governing Council’s  membership is double that, with no published minutes, at least to date. They do have one thing in common though- press conferences hosted by the Head of the institution- although the Fed has only recently adopted that practice and limits it to one a quarter, as against the ECB’s regular slot on the first Thursday of the month.

The press conferences also differ markedly however. Ben Bernanke has held court at all of the Fed’s to date, and things may change when Janet Yellen takes over, but  there is a much more open  atmosphere than in Frankfurt and it probably reflects more than the personalities involved. This may in part be due to the nature of the audience, which is smaller in number than for the ECB and made up largely of ‘Fed-watchers’, who like the Kremlinologists of old are attentive to the slightest hint of any change in policy. Few, if any, foreign journalists appear to be present and the questions are usually to the point and illicit equally straightforward responses from the Chairman. One senses that there is an implicit belief that the population have a right to know what the Fed is thinking and the questioners seek to tease out any areas where there is a lack of clarity, although of course central bankers are not omniscient and any statement of intent is always contingent on events.

The ECB conference is more formulaic ( the President opens by reading a much longer statement than that issued by the Fed ) and the atmosphere feels very different, at last as viewed on television,  with the ECB President often striking a defensive and sometimes peevish tone, with attempts to justify past policy decisions (‘ the events of the past month have vindicated our  stance’). One is always left with the impression of an audience seeking to illicit answers from a Bank reluctant to elaborate,  which leaves an unsatisfied taste. A good case in point is OMT, which is regularly raised and is met with the response that all has been explained at some earlier meeting  although if that were the case the question would not arise. The sheer numbers involved in setting ECB rates inevitably makes for differing views in the Council and that may explain the President’s  caution in response to some questions but at times the dichotomy between the Bank’s  current stance  and its stated policy aims is glaring; the ECB is  forecasting inflation in 2015 at 1.3%, for example, which does not appear consistent with its definition of price stability (‘below but close to 2%’) and implies monetary policy is too tight, even after the recent rate reduction.

Monetary policy in the euro area is  certainly more pragmatic under Draghi and the ECB has moved a long way from its Bundesbank-centred roots. The  press conference has  also ditched some of  the rituals common in President Trichet’s time, when everyone listened for some key words, like ‘strongly vigilant’, as a signaling mechanism- what’s wrong with saying  that ‘ we are likely to raise rates at the next meeting in the absence of unforeseen events’ rather than use some code?. The questions  also vary in quality and relevance it also has to be said, with some journalists seeking comments on specific country issues which are beyond the remit of the ECB (‘Draghi praises Ireland’s/ Portugal’s/ Italy’s/  stoic adherence to fiscal rectitude’). One final point. President Draghi’s pledge ‘to do whatever it takes to preserve the euro’ was queried by a (German) journalist at one press conference, with the latter pointing out that Governments and ultimately electorates would decide the single currency’s fate. An unusual intervention , highlighting that the ECB is ultimately accountable to the citizens of the  euro area, and that it is their Central Bank.