- The US Federal Reserve has already increased its funds rate target eight times since late 2015, leaving it in a range of 2% to 2.25%.
- Based on the median forecast for FOMC members, it sees another rate hike in December, three in 2019 and an additional increase in 2020.
- Rabobank says the Fed is wrong to assume that “this time is different”.
The US Federal Reserve has already lifted official interest rates eight times since late 2015, including three 25 basis point increases this year alone.
Based on the median forecast offered by individual Federal Open Committee (FOMC) members in September, it’s likely the Fed will hike its funds rate again in December, and another three times in 2019 and once again in 2020, moving monetary policy into what many regard as being restrictive territory for US economic activity.
While financial markets are pricing in considerably less hikes from the Fed over the same period, with official borrowing costs set to increase regardless based on the prevailing view, it could see the US yield curve invert — leaving two-year bond yields higher than 10-year equivalents — a scenario that has almost always signalled that a US recession is just around the corner.
So why would the Fed want to generate a signal that markets know all too well usually means a recession will arrive soon after?
According to Philip Marey, Senior US Strategist at Rabobank, it’s because the Fed is too “overconfident” in the view that “this time is different”.
“Blinded by strong coincident and lagging indicators, such as strong GDP growth and low unemployment, the Fed is dismissing an important leading indicator in the form of the yield curve, which is heading for an inversion if the Fed keeps up the pace of rate hikes,” Marey says.
“Historically, a yield curve inversion is followed by a recession in about 12-18 months. Therefore, we have been warning the Fed against inverting the yield curve.
“However, the majority in the FOMC appears willing to invert the yield curve, because they believe that this time is different. In their mind, an inversion would indicate that monetary policy is restrictive, not that a recession is imminent as history teaches us.”
While a majority of Fed members, based on their latest year-ended funds rate forecasts, don’t appear to be concerned by a potential yield curve inversion, Marey certainly is, warning the current trajectory of economic growth — helped by prior weakness in the US dollar, corporate and personal tax cuts, as well as infrastructure spending — is unlikely to be repeated.
“If we look at the economy we should keep in mind that GDP growth in 2018 is boosted by large tax cuts. However, these effects are likely to fade in 2019 and beyond, unless we see further tax cuts,” he says.
“Meanwhile, the trade war with China will raise taxes on imports, raising costs for importing US firms, and undermining consumer purchasing power. At the same time, retaliation by the Chinese government will make it more difficult for US firms to export to this large market.
“Finally, emerging economies are feeling the pain of rising US interest rates and the rise in protectionism. This will also undermine global growth, and indirectly US growth.”
Based on his calculations and the expected path of policy tightening indicated by the Fed, Marey says the US yield curve is likely to invert by the end of next year, greatly increasing the probability of a recession by early 2021 in his opinion.
“In our view, they will have gone too far by then, raising the risk of recession above 50%. By the time we get to 2020 we expect the signs to be clear, even to the Fed,” he says.
“We are likely to see history repeating itself with the Fed inverting the yield curve, stopping the hiking cycle too late, causing or at least contributing to a recession.”
Given many now understand the history of yield curve inversions and subsequent recessions, such a scenario also carries the risk that households and businesses might begin to position for an economic downturn, perhaps exacerbating and bringing forward any potential slowdown.
Based on the ongoing flattening of the curve in recent years, that theory may well be put to the test in the months ahead.
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