By now, you have probably heard that the yield curve has got flatten and will likely invert in 2019. What does this mean? Specifically, economists and investors look at the yield of the 10 year treasury note and subtract that rate from that of the 2 year treasury note. Rationally, investors want higher rates for long term notes as compared to short term ones. So, we expect the 10 year note yield to be higher than that of the 2 year note (with credit quality and other factors being the same). The difference in these rates, we call the yield curve. It is expected to be positive, when long term rates are expected to be higher (and there is an outlook for growth).
When the differences of the longer-term note approaches that of the short-term note, we see a condition in which bond buyers are hoarding all available long-term bonds. In essence, they expect long-term rates to fall below current levels in the bond market. This has been a rather reliable predictor of a downturn in the economy in the next 12-20 months.
In following plot, I have the yield of the 10-year note minus the 2-year note and the effective funds rate. It seems the rising of the effective funds rate creates some compression in the yield cure. It also seems to me that the Federal Reserve never gets the interest rate right. It seems they go too high when trying to fight inflation. Well, the argument is that they fight inflation with rate increases. This was the prevailing wisdom coming out of the 1970s when inflation was a huge issue. Most governmental banks, including the US Federal Reserve, target an inflation rate around 2% (plus or minus).
The red ovals show when sharp increases in the federal funds rate corresponds to compression or flattening in the yield curve. With the exception of the mid 1990s, notice that recessions followed a year or two later. No Bueno for 2019 and 2020!
It looks like the Federal Reserve overdoes it on the funds rate. Maybe they caught wind of this and back off increases in 1995, giving us a nice period of growth in the late 1990’s. Again, rapid increases in the funds rate brought compression in the yield curve in 2004/5. We might well be in this period again.
I question if inflation is properly measured. For instance, digital solutions, on-line ordering, Uber services, innovation in flying, have all reduced the costs to buy things, look for items, hire drivers, fly, and the cost savings of these services have changed what and how we purchase. That is a reduction in price and deflation in the costs of what we buy. For instance, in 1997, I purchased a Honda Civic for a bit over $15,000. Today, a far more efficient and technically advanced Honda Civic is available for around $19,000. In 21 years, its price grew about 24%. That is abysmal inflation and surely deflationary when one considers that the 2019 model offers more features. In fact, we see such reduction in prices largely because we buy things from lower labor cost countries and firms have reaped benefits from innovation and costs savings in scaled business models.
The Federal Reserve says they look at the changing basket of goods purchases, but then how are they constantly overdoing it on the funds rate when it matters most? Is the Federal reserve capturing the movement to car services, like Uber and Lyft, over even owning a car? I think we experience deflation in various items, like travel and many services, due to the gig economy. And now, energy costs are way down historically (thanks to the spat with Saudi Arabia and Iran). Yes, food prices are up and many labor services that are not gig oriented are showing price increases. For sure, measuring inflation is not as easy as it sounds. And, I think the Federal Reserve should poll people on what they buy, not what we think they buy. Ask a credit card company to formulate a price index.
I like to look at the Real Median Household Income. This is median household income corrected for inflation (and inflation might not be properly measured). There is recent good news, the “median” American family makes more than ever. However, there was a long stretch when real median household income was down and at best flat. In the next plot, you can see that the rising of the federal funds rate seems to also correspond to the reduction in the real median household income.
Let’s hope this coming year it is more like 1995 and we have a healthy stretch of growth ahead of us. If it is like 1995, the Federal Reserve should realize that they over did it and back off rate increases (as they did post 1995). Here’s a great graphic that captures the commentary of the Federal Reserve governors in relations to the flattening yield cure.
If we have a recession, it will be initiated by funds policy of the Federal Reserve. A little inflation might actually help local economies that have not seen housing prices move much and give employers a reason to share earnings with workers through wage increases.
Perhaps Santa will bring a funds rate reduction, too! That’s on my list to Santa!
Professor Walker provides keynote talks, seminars presentations, executive training programs, and executive briefings.
About Russell Walker, Ph.D.
Professor Russell Walker helps companies develop strategies to manage risk and harness value through analytics and Big Data. He is Clinical Professor of Managerial Economics and Decision Sciences at the Kellogg School of Management of Northwestern University. He has worked with many professional sports teams and leading marketing organizations through the Analytical Consulting Lab, an experiential class that he founded and leads at Kellogg.
His most recent and award-winning book, From Big Data to Big Profits: Success with Data and Analytics is published by Oxford University Press (2015), which explores how firms can best monetize Big Data through digital strategies. He is the author of the text Winning with Risk Management (World Scientific Publishing, 2013), which examines the principles and practice of risk management through business case studies.