Peter Donisanu is an Investment Strategy Analyst at Wells Fargo Investment Institute, and Dr. Brian Jacobsen is a Senior Investment Strategist on the Multi-Asset Solutions Team of Wells Fargo Asset Management.
Rising short-term rates and a flattening yield curve in the U.S. bond market have some investors asking whether the U.S. economy is headed for a recession in 2018 – and for good reason. Since 1978, the U.S. has had five recessions, and each one was preceded by an inverted yield curve. The yield curve inverts when short-term rates move above long-term rates. Currently, however, the yield curve is flattening, not inverting. There’s a big distance between an upward-sloping yield curve and a downward-sloping (inverted) yield curve. It really shouldn’t surprise anyone that the yield curve—as measured by the yield on the 10-year U.S. Treasury note and the 2-year U.S. Treasury note—is flattening. In fact, it is flattening at nearly the exact same pace as it has during previous periods when the Federal Reserve (Fed) was hiking rates.
Source: Bloomberg and Wells Fargo Asset Management
In the above chart, Fed hikes are shown by scanning from the left to the right. We fit straight lines to the chart to show the comparison of the hiking cycles. In the equations, “y” is the slope of the yield curve (10-year yield minus 2-year yield) and “x” is the target for the federal funds rate. These lines are nearly parallel, showing that just like in previous hiking cycles, for every increase in the federal funds rate, there was approximately the same reduction in the slope of the yield curve. Simply extrapolating out from the current path of rate hikes suggests we could get a flat yield curve when the target federal funds rate hits 3.35%. Based on the current (April 2018) Summary of Economic Projections from the Fed, the Federal Reserve thinks it will get to a target rate of around 2.8% to 2.9%, meaning it plans on stopping just before the yield curve flattens.
What could lead to an inverted yield curve and a potential recession?
A few patterns tend to coincide with an inverted yield curve that foreshadows a downturn in the U.S. economy. First, rising rates of inflation (measured both by the headline core Consumer Price Index (CPI) basket and core Personal Consumption Expenditures (PCE) index) tend to track the yield curve’s progression into negative territory. Second, the Fed has typically increased its benchmark rate at a notable pace to address rising prices. Given the absence of significant inflation pressures, we could also see the curve invert should the Fed make a policy mistake by increasing short-term rates in the absence of these factors.
Source: Bloomberg, Wells Fargo Investment Institute; 4/18/18
While an inverted yield curve has typically been a good forward-looking indicator of a recession, it is not perfect. The chart above shows that there have been times in which the yield curve inverted but a recession did not follow.
How do today’s developments compare with historical pre-recession periods?
In the past five economic cycles, the Fed hiked rates an average of 180 basis points (bps; 100 bps equal 1.00%) in the 12 months leading up to prior curve inversions. Similarly, core CPI and PCE inflation rates rose by an average 0.8% and 0.7% percentage points (respectively) over the same period of time. This is quite notable when compared to the past twelve months; over that time period, the Fed has increased rates by only 75 basis points, while the percentage point change in core PCE is near zero and core CPI negative. From this vantage point, trends in inflation and Fed policy have yet to signal an impending yield curve inversion.
While the threat of an inverted yield curve is disconcerting to some investors, the Wells Fargo Investment Institute does not expect curve inversion in the near term. We look for inflation to increase at a modest pace throughout 2018, allowing policymakers at the Fed to continue to raise rates at a steady pace. At this point we do not think investors should be overly concerned with a flattening but not yet flat interest rate curve and even less concerned that a recession is imminent.
Although Treasuries are considered free from credit risk they are subject to other types of risks. These risks include interest rate risk, which may cause the underlying value of the bond to fluctuate.
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