When the FOMC raises rates late in a tightening cycle, the yield curve always flattens and the yield curve usually inverts. Inversions have always been followed by recessions. So it is understandable that some policymakers have indicated they would become cautious, or even resist, further rate hikes if the yield curve were to invert. We see it as a close call whether or not the yield curve will invert. But recession risk increases as the yield curve flattens and that risk will build as the FOMC moves toward neutral, and especially beyond neutral. Here we identify those who have raised concerns about tightening so much that the yield curve inverts. There will be an ongoing discussion in the minutes and in talks by FOMC participants that we will continue to monitor.
Counting Heads: Who’s Worried
Almost everyone is concerned about an inversion of the yield curve, given that it is such a reliable indicator of recession. But some more than others. And some would be concerned if the yield curve inverts, but the participants expect it to steepen instead as a result of ongoing balance sheet normalization and increased Treasury issuance. If that were not the case, add these to the participants who already express serious concern, and, of course, pay close attention to whether the yield curve steepens or continues to flatten! This concern could play a decisive role in whether the FOMC follows a slower path than we and the project and whether the FOMC is prepared to raise rates above neutral. We “count heads.” Specifically, we identify participants who have indicated they would not want to tighten to the point that the yield curve inverts and those who are less concerned.
The Worried Group
“I am getting concerned about the flattening yield curve.” “If we go too aggressively to the point where we invert the yield curve I would take that as a very negative signal, and our risk of recession would go up…My main point about that is I don’t think we’re in a situation where we have to push so hard.”
“I don’t want to knowingly invert the yield curve.” “It would give me great pause” if a rate hike would invert the yield curve.
“I have had extended conversations with my colleagues about a flattening yield curve…we are aware of it. So it is my job to make sure that doesn’t happen.”
The flattening of the yield curve is a “signal of caution…at least a yellow light flashing.”
Would Worry If Yield Curve Inverts but Expect the Yield Curve to Steepen
He said that the shape of the yield curve is a consideration in determining the appropriate pace of rate hikes. But he expects the yield curve to steepen over the medium term. But “if that doesn’t occur in a way that I anticipate, then I’d be willing to slow the pace of increases.”
A truly inverted yield curve “is a powerful signal of recessions.” It happens “when the Fed is in a tightening cycle, and markets lose confidence in the economic outlook.” “The flattening of the yield curve that we’ve seen is so far a normal part of the process, as the Fed is raising interest rates, long rates have gone up somewhat–but it’s totally normal that the yield curve gets flatter.” But he also said he is less concerned because he expects the yield curve to steepen as a result of balance sheet normalization.
“You sort of expect given the increase in deficits that’s being reported now, and the additional funding, that we would [be] moving to a…steeper yield curve, so I think that any concerns that we may have expressed before about an overly flat yield curve, I’d put off to the side until we see things play out for some time.” Still, he cited the possibility of a yield curve inversion as another factor supporting a slower pace.
“I actually am not as worried about it.” He does not think a flatter curve signals a recession. Quarles
“I’m not viewing the current flattening of the yield curve as a particular signal of recession.” Why Worry?
Everyone should worry! Short rates move more than long-term rates. As a result, the yield curve flattens during a tightening cycle. As tightening progresses, the risk of recession rises as well. An inverted yield curve identifies the point when the tightening has become especially aggressive.
Chart 1 shows that powerful regularity. That underpins the concern that an inversion of the yield curve signals recession. We can see that an inversion of the two-ten slope precedes all recessions since 1961 and there has never been a recession over this period that was not preceded by an inverted curve.
In Chart 2, we show the probability of a recession over the next four quarters based on a probit model where the yield curve slope is the only independent variable. According to the probit regression, the probability of a recession over the next four quarters is low today (about 10%), but rises as the fund’s rate continue to increase and monetary policy moves into a restrictive posture. Using our rate projections, we estimate that the probability of recession would rise to about 40% in 2020, which is almost as high as the estimated probability of recession before the last two recessions.
But This is Not the End of the Story
The probability of recession is also affected by the term premium (a mitigating factor today) and by the fund’s rate gap, the difference between the real fund’s rate and its estimated neutral rate.