The Fed is Steam Rolling the Yield Curve

The yield curve has never been this flat before the US Federal Reserve has begun a tightening cycle.  Never. Not even close. Historically the shape or difference between the 2- and 10-year yield is 150-200bps, with longer term yields exceeding the front end. This is normal. The central bank confronting an expansion with term premia relatively high then begins to raise rates to slow the economy and inflation. As the policy rate eventually approaches neutral, the curve flattens as the longer-term outlook is tempered. Occasionally, the Fed goes too far, flattening and even inverting the curve, ala 2018. The next move is almost always a cut. 

The chart below shows the Fed Funds Rate (Yellow on LHS), the 2/10 Yield Curve (white on RHS), and the shading being the period immediately prior to the last 3 hiking cycles. The shaded boxes highlight where the white line (curve) has been just preceding the hiking cycles. On the right-hand side, the curve is currently a mere 38bps. Dangerously close to flat before even a single 1bp of rate hikes has been delivered. 

If we look at the US 2/10 curve, as projected by markets in 1 years’ time, it is already inverse. The only other time this was the case was in 2018. The next move was a cut. Again, we have gone back nearly 30 years. 

What to make of this? The Fed will and should be raising rates in March. Hindsight is of course a wonderful thing and the pandemic created huge uncertainties, but the Fed is probably around a year too late. They are now in the position of having to hike rates in reasonably short order in an expansion that is quite late cycle. The economy is slowing from its stimulus frenzy of the last 2 years.  Inflation is slowing, the pace and extent can be debated but no one disagrees that coming months and quarters are about to see a deceleration in price gains. Finally, financial conditions are tightening. The 30yr mortgage rate is now the highest in 3 years, equities are weaker and credit spreads wider. 

Why does the curve matter anyway? A steep curve is positive for bank profitability and therefore loan and credit creation. Banks borrow short and lend long(er), so a steep curve supports their ability to finance the economy.  Part of the goal in the tightening cycle is to slow credit by flattening the curve to slow the creation of credit.  The curve is also signalling that this is not the 1970’s. The bond market has high confidence that the Fed will tame inflation returning conditions to normal of modest growth and little inflation.  That is why the 10-year yield is struggling to move above 2%.  The market is pricing the Fed Funds rate to increase to just below 2% which would be the lowest after a tightening cycle in history. 

The delicate tightrope of tightening policy too late with a curve that is already looking like a pancake raises the risks of the process being interrupted. No one is talking about that but if, in several months’ time, after a few rate hikes, the curve is flat or inverse and inflation is moderating steadily, we could easily see the Fed take a ‘pause’ to assess. 

For what it’s worth, the average forecasting error overtime between both the market and the Fed itself for policy hikes has been 1-1.25% over a two-year period. That is to say that both the bond market and the Fed have a habit of expecting more to be delivered than actually is. 

Our friends at Piper Sandler research highlight in the chart below the actual Fed Funds rate together with the market’s expect path for the rate in February each year. 

Food for thought.