What the yield curve is really telling us
Economists and financial types have gone wild over the last couple weeks debating the implications of the yield curve inverting — short-term interest rates rising above long-term rates.
Why it matters: It would be bad news if the Fed is steering the economy straight toward recession-ville. But bond market indicators so far are more consistent with a slowdown in activity that helps rein in inflation without slipping into an outright economic contraction.
- This is a market event that has historically predicted recessions, hence the alarm, as Axios' Matt Phillips has covered. But this may be a case where the chatter has gotten ahead of the reality.
The theory: The Fed directly controls short-term interest rates, while the rate on longer-term rates is set on the open market, as traders buy and sell securities based on, among other things, what they think the economic future look like.
- If they think growth and inflation are going to remain high into the future, they bid longer-term rates up. If they think that there will be a slowdown or recession that triggers Fed rate cuts, longer-term rates tend to fall.
- That's why something like the event that briefly occurred this week, with 10-year yields rising above two-year yields, is viewed as a recession predictor.
Yes but: If you believe that the Fed will be reactive to incipient recession risk, a yield curve inversion, especially a small one, is more consistent with the economy coming in for a soft landing than crashing into recession.
- Arguably, the Fed's own rate expectations are consistent with yield curve inversion. The median official projects that the short-term federal funds rate will rise from near-zero earlier this month to 2.8% at the end of 2024 before settling into a long-term rate of 2.4%.
- It is distinctly possible that this tightening cycle has its own version of the 2019 "mid-cycle adjustment," three rate cuts in the midst of an expansion.
What they're saying: Krishna Guha and Peter Williams at Evercore ISI describe in their research notes a policy path of "up hard then down again." In other words, that the Fed will raise rates aggressively to try to rein in inflation, then cut rates as the economy stabilizes at a slower, steadier growth rate.
The bottom line: The risk of a recession in the next couple of years is real, and the Fed is in a delicate spot. But nothing about the bond market swings in the last couple of weeks means it's inevitable.