September 4, 2019

The yield on the 10-year note has fallen 1.3% since the end of yest year to 1.5% in part because the Fed said that it intended to reduce the funds rate because of a feared slowdown or recession caused by trade policy in the not too far distant future.  At the same time the inflation rate has remained steady at a level slightly below the Fed’s 2.0% target rate.

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 1.5%% and inflation at 2.0%, the real 10-year rate is negative 0.5% 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 could 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 1.75% and to climb further in 2020 to 2.3%.

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 1.5% and the funds rate at 2.1%, the yield curve today is already slightly inverted  by 0.6%.  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 or 2020.

Stephen Slifer


Charleston, SC