The Fed is downplaying a key recession indicator that's flashing yellow - but some on Wall Street think 'they are wrong again'
- The US Treasury market's sending an ominous signal about the economy's future, as long-term interest rates slip further toward their short-term counterparts.
- This trend, known as a flattening of the yield curve, can be a signal of recession if the curve fully "inverts" and long-term rates actually dip below short-term ones.
- "The Fed was wrong about the curve before. More likely than not, we believe they are wrong again," writes a Citigroup interest rate strategist in a research note.
Federal Reserve officials and Wall Street traders should be cautious about dismissing an ominous sign emanating from the US Treasury market.
Bonds tend to act rather oddly ahead of recessions as investors begin to expect lower future returns on investment. When that happens, the yield on long-term notes falls below its short-term counterpart. The phenomenon, known as a yield curve inversion, has invariably preceded an economic downturn.
The last time it happened was in 2007, just before the economy entered its deepest recession in generations. And now the yield curve is threatening to invert again, with the spread between 10- and two-year Treasury note yields now at its lowest level since that fateful year.
Some Fed officials including Chairman Jerome Powell have dismissed the trend as unlikely to be sending any kind of recessionary signal this time, with the Fed still expecting the US economy to grow 2.7% this year and 2.4% in 2019.
"Former Fed Chair Yellen and Chair Powell have downplayed the recent curve flattening," wrote Ruslan Bikbov, interest rate strategist at Citi, in a research note.
"We don't find their arguments convincing. The Fed was wrong about the curve before. More likely than not, we believe they are wrong again."
In particular, optimists say the recent flattening trend is being magnified by a low "term-premium" - the notion that it costs more to borrow over a longer period - given the Fed's massive $4.4 trillion balance sheet, which it is only gradually unwinding.
But Bikbov says "the notion that a flat curve should be ignored because of low term premiums is misplaced. Term premiums are far from being historically low."
He adds that for now, "recession probabilities remain low since the curve is still far from being inverted, but will grow rapidly if the curve flattens further: the relationship between the curve and recessions is highly non-linear. If that happens, investors should take the curve very seriously and ignore the Fed's skepticism."
"The extreme optimism about economic growth this year has cooled as the hard data have come in constructive but not exceptional," wrote Michelle Meyer, Bank of America Merrill Lynch's US economist, and her colleagues in their research.
"In the near term, we think all eyes should be on the US consumer to inform us how and when the fiscal stimulus will kick in," she added. "Early survey evidence suggests that consumers may have embraced a somewhat frugal attitude when it comes to responding to the windfall cash from tax cuts."
Deutsche Bank economists predict the curve will invert in 2019 as the Fed keeps raising interest rates by a quarter percentage point every quarter, as markets expect.
"If the Fed continues to raise rates according to our forecast and the term premium does not recover, the yield curve would invert by the end of 2019, potentially as early as June of next year," they write in a note.
The real trouble may not come until two years out, they estimate.
"Our full recession probability model puts the odds of a recession in the next twelve months at about 10%. Once the forecast window gets further out, however, the yield curve is showing elevated recession probabilities," the economists write. "With our forecast projecting output growth to slow below potential in 2020, the inversion of the yield curve would be a meaningful signal regarding the specter of a looming recession."
