The next Fed meeting is less than a week away and most analysts are looking at another big rate hike. Hardly anyone expects this to do anything against inflation, given that the Fed cannot refine oil into gasoline, increase the grain harvest, employ airlines or unload container ships. , all of which fueled the acceleration in inflation even as the money supply began to roll. But there are growing fears that even another big rate hike could overtake and crush the economy, especially given the flattening of the yield curve in recent weeks. In our view, there is some risk of yield curve inversion, but that is not a given, and even a slight inversion is not an automatic recession trigger.
Now, when we look at the yield curve, we’re not using the 2-10 year segment that has been getting most pundits’ attention lately. We believe the importance of the yield curve comes from its relationship to banks’ funding costs (short-term rates) and lending income (long-term rates), with the gap between them influencing potential profit margins banks on new loans, which stimulates loan growth. . Typically, a large spread means big profits and aggressive lending, while a deeply negative spread can signal a credit crunch. Banks don’t get a lot of funding through 2-year CDs. They finance themselves mainly through retail deposits and interbank markets, which are much shorter term. We believe the 3-month Treasury yield is a better approximation, so we use the 3-month to 10-year yield spread. That spread, as shown in Figure 1, has narrowed sharply since early May, from more than two full percentage points (a multi-year high) to around half a point at Tuesday’s close.
Exhibit 1: The rapidly contracting yield curve gap
Source: FactSet, as of 07/20/2022. 10-year and 3-month US Treasury yields at constant maturity, 12/31/2014 – 07/19/2022.
The flattening came largely at the short end of the curve. The 10-year yield has fallen just 0.11 percentage points since the spread peaked, albeit with great volatility along the way – it closed May 6 at 3.12%, climbed to 3.49% on June 14 and closed Tuesday at 3.01%.[i] Meanwhile, 3-month yields jumped from 0.85% on May 6 to 2.52% now.[ii]
By the way, 2.5% is the upper end of the fed funds target range if the Fed were to hike rates by 0.75 percentage points next week, which strongly indicates that the move is already integrated. It would be very odd if that weren’t the case, given how much chatter there has been. Markets are efficient and are likely to reflect current views about what might happen in the near future. Additionally, as shown in Chart 2, 3-month yields have had a strong tendency to outperform the Fed.
Exhibit 2: Prescient’s 3-month Treasury yield
Source: FactSet, as of 07/20/2022. Upper limit of the target federal funds rate and constant 3-month maturity US Treasury yield, 12/31/2014 – 07/19/2022.
It is therefore far from certain that a single sharp rise in rates will be enough to invert the curve next week. He is possible, if expectations of further increases increase or if inflation expectations fall. But not automatic.
Still, it’s worth considering what a shallow reversal would mean – and we see two big reasons why it wouldn’t be a recession trigger. On the one hand, notice that we said earlier that the yield curve influences banks’ costs and revenues – we didn’t say they were the same. The yield curve simply indicates potential changes in the banking world. These days, the signal is not so strong. Frustratingly, the national average filing rate, according to the FDIC, is 0.10% thanks to an astronomical filing glut.[iii] Meanwhile, the prime lending rate is 4.75% and the average 30-year fixed mortgage rate is 5.5%.[iv] These numbers are not consistent with a credit crunch that would force businesses to cut spending and be efficient to survive a funding freeze.
Second, money doesn’t care about borders. Banks can borrow in one country, lend in another, and hedge currency risk with minimal hassle, arbitrating global rate differences. The United States currently has some of the highest rates in the developed world, which makes it very attractive to borrow cheaper in continental Europe or Japan and lend here. This is one of the main reasons the dollar has strengthened this year – all things being equal, money is flowing to the most profitable asset. Whether overall the money supply has contracted sharply, limiting the amount of money that can flow here to take advantage of higher rates, so that would be one thing. But central banks outside the United States are not depleting reserves much. The GDP-weighted global yield curve is not flirting with a significant inversion either.
Finally, it should be noted that the yield curve is not a trigger. It is true that the yield curve often inverts before recessions, but the lag is quite variable. Bear markets often precede recessions too, so even if the yield curve points to a recession, how much of that weakness is already reflected in stocks? Probably a lot, in our opinion, given the ubiquitous headlines exploring the concept.
We’re not saying the yield curve doesn’t make sense. A deep US reversal with parallel moves globally would be concerning. But we are not there yet, and there is no high probability that it will be imminent. So while we may have a shallow recession due to all the supply disruptions this year, the likelihood of spirals due to Fed-led credit tightening seems remote for now.
[i] Source: FactSet, as of 07/20/2022.
[iii] Source: Federal Reserve of Saint-Louis, as of 07/20/2022.