Chief economist update: Fed flattens the yield curve

Given the US equity market's reaction to the latest US Federal Reserve missive, one would think that Wall Street is against strong(er) growth.

All major benchmark indices - DJIA, S&P 500, Nasdaq and Russell 2000 - closed lower after the Fed announced the widely-anticipated 25 basis point hike in the fed funds rate to 1.75%-2% at its FOMC meeting and according to Fed chief Powell, "is another sign that the US economy is in great shape. Growth is strong. Labour markets are strong. Inflation is close to target."

Perhaps, growth is even stronger.  The movement in the dot plots indicates that Fed participants now expect another two more rate hikes (instead of one) for a total of four this year.

This is well and good and certainly a consequence of the revisions in the Fed's growth, unemployment and inflation forecasts in the June quarter: 2018 GDP growth was revised higher to 2.8% (from 2.7% predicted in the March quarter) and unchanged at 2.4% in 2019, the unemployment rate was lowered to 3.6% for 2018 and 3.5% for 2019(from 3.8 and 3.6%) and inflation, as measured by the core PCE price index, raised to 2% in 2018 (from 1.9%) and 2.1% in 2019 (unchanged).

So what's wrong with you people of Wall Street? It could be that the Fed's change in tone from meek and mild to a little aggression has got the forward-looking financial denizens spooked.

For one, the flattening of the yield curve is ominous. Though it's not yet inverted (one presages a recession), it's heading lower. The yield differential between the two-year and 10-year US Treasuries has dropped to 0.4% - its lowest level since 2007 (but was heading higher at the time).

A more relevant example is in 2005 when the yield curve consistently flattened from 2.7% in 2003 before becoming inverted by 2006. At the time, Fed chief Alan Greenspan called it the "interest rate conundrum" - a state where the long end isn't responding to the Fed's rate hikes - and reasoned that it was due to the global savings glut and increasing globalisation.

In testimony before the US Senate Committee on Banking, Housing, and Urban Affairs on February 17, 2005, Alan Greenspan remarked that:

"Long-term interest rates have trended lower in recent months even as the Federal Reserve has raised the level of the target federal funds rate by 150 basis points. This development contrasts with most experience, which suggests that, other things being equal, increasing short-term interest rates are normally accompanied by a rise in longer-term yields. The simple mathematics of the yield curve governs the relationship between short and long-term interest rates. Ten-year yields, for example, can be thought of as an average of ten consecutive one-year forward rates. A rise in the first-year forward rate, which correlates closely with the federal funds rate, would increase the yield on ten-year US Treasury notes even if the more distant forward rates remain unchanged."

Whatever the underlying reason is still up for debate but what could not be mistaken is that the inverted yield curve was followed by the 2008 recession, as it had in the US recessions of 1990 and 2001.

The current Fed chairman claims that short term rates are rising because of the hikes and the smaller lift in the long-term yields to safe-haven buying.

Say what? The Fed projects good growth going over at least the next three years and investors are buying safety instead of risk assets? That, indeed, is a conundrum.

As yet there's still no need to panic, the flattening yield curve could still reverse and widen as it had in 1994 and 1998.

But watch the yield curve for it would provide an indication on whether or not the Fed is tightening more aggressively than it should.

Ben Ong is the Director of Economics and Investments at Rainmaker Group. He previously worked as a fund manager, economist, asset allocation strategist, portfolio analyst and stock market analyst. Check out his economics analysis here.

Read more: FedFederal ReserveAlan GreenspanWall StreetBankingDJIAFOMCGDPHousingNasdaqPowellRussellS&Pten-year U.S. TreasuryU.S. Senate CommitteeUrban AffairsUS Treasuries
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