March 29, 2019

The yield on the 10-year note has fallen 0.9% in the past couple of months from 4.9% to 4.0% in part because the Fed said that it was done tightening and the funds rate would be unchanged for the foreseeable future.  At the same time the 20% correction in the fourth quarter of last year created an expectation for slower growth ahead.  And the inflation rate has edged lower in recent months instead of rising as had been anticipated.  As a result, all long-term interest rates have declined sharply.

During the past several business cycles the 10-year note has averaged 2.0% higher than the inflation rate.  With the yield on the 10-year note today at 2.4%% and inflation at 1.7%, the real 10-year rate is 0.7% which is very low by any historical standard.

If the Fed keeps the inflation target at 2.0%  and the rate on the 10-year tends to average 2.0% higher than that, the yield on the 10-year should eventually reach 4.0%.  However, it should not rise to that level for some time if the inflation rate remains relatively steady.  At the end of 2019 we expect the yield on the 10-year note to climb slightly  to 2.75%

When will rates have risen high enough that the economy could dip into recession?  The yield curve — which is the difference between long-term interest rates and short rates — will give us a hint.   When the Fed tightens aggressively short rates typically move higher than long rates and the yield curve will “invert”.  When it does that is almost invariably a sign that the economy is about to dip into recession.  Thus, an inverted yield curve is a closely watched indicator that a recession may be approaching because it tells us that Fed policy is “too tight”.  Note how in both 2000 and 2007 the curve inverted by 0.5% or so six months to one year prior to the onset of recession.

Today, with the 10-year yield at 2.4% and the funds rate at 2.4%, the yield curve today is flat and some parts of the curve are slightly inverted.  However,  a curve that inverts because the Fed has raised short rates quickly and they eventually become higher than long rates is a danger signal because the inverted curve is a signal that Fed policy is “too tight”.  But in the recent case the curve has inverted slightly because long rates have fallen sharply and are now below short rates.  A curve that inverts because long rates have fallen sharply does not carry the same danger signal as when the curve inverts because short rates are rising rapidly.  There is a big difference.  The inverted curve today is not a harbinger of an impending recession

For us to make a recession call we need to see two things.  First, the funds rate will need to be well above the neutral rate (probably about 5.0%), and the yield curve should be inverted.  Neither of those conditions seem likely to be met by the end of 2019.

Stephen Slifer


Charleston, SC