The Fed and the Yield Curve - Recession Ahead?

September 26, 2018

 

So the Federal Reserve decided to raise rates further today, pegging the Federal Funds Rate (FFR) at about 2%. Just a few years ago, that rate was on the floor at or near 0%, being a part of the Fed's accommodative monetary policies that included Quantitative Easing, Operation Twist, and others.

 

Normally, when the Fed raises rates, other interest rates on bonds with more distant maturities also rise. Despite what the headlines say about a flattening yield curve, this is in fact what is currently happening. While it is true that the spread between 2-year treasuries and 10-year treasuries has narrowed, the 10-year yield has been steadily increasing, along with the FFR and 2-year yields, since the beginning of the Fed's current policy of "returning to normal."

 

Normally, when economists and market participants observe a flattening yield curve, they get worried. This is because such phenomena is correlated with an oncoming recession. Why? When the yield of longer term bonds dip lower than shorter term bonds, investors are pricing in lower future growth - or even negative growth - which would signal a recession. It's important to note that flattening or negative yield curves do not cause recessions, they are just correlated.

 

I've addressed that the flattening of the yield curve on treasury bonds is not happening because longer term yields are falling, and that a flattening yield curve does not cause a recession. Do I think a recession is still on its way? Yes.

 

The FFR is like an anchor point for all other interest rates in the economy. When the Fed raises the FFR, all other interest rates tend to rise. When interest rates rise, consumer and producer spending tends to decrease, because so much of that spending is fueled through borrowing. As consumers and producers shore-up their balance sheet, spending decreases and a recession follows.

 

You see, interest rates coordinate spending and investment in a free market. When interest rates are high, it is an indicator to save and not spend. As savings increase, interest rates fall, creating a signal to spend. So, when producers observe interest rates, they borrow and invest in new projects when interest rates are falling, as that serves as an indication that savings are increasing, and that spending will follow in time.

 

The Fed continuously mucks all of this up by messing with interest rates to encourage spending. By keeping interest rates artificially low with the FFR and other operations, they entice producers to borrow and invest in new projects and for consumers to keep spending. This eventually creates inflation; producers and consumers are borrowing against savings that don't exist, which means the Fed must "print" more money to buy bonds to keep interest rates low. This borrowing and spending drives inflation, and as inflation rises, the Fed must eventually increase interest rates to fight it, as per its mandate. That is exactly what is happening right now. The higher the rate of inflation, the higher the Fed will raise rates, and that almost always brings on a recession:

 

 

So, yes, I believe a normal business cycle is still in operation and that as the Fed raises rates, the chance of a recession only grows - flattening yield curve or not.

 

For more on this, check out Austrian Business Cycle Theory.

 

 

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