CAN THE INVERTED YIELD CURVE SURVIVE ANOTHER RATE HIKE?

Will the Federal Reserve raise interest rates again next week, when the FOMC convenes on March 27 and 28? Another way of asking the question: is the central bank willing to add momentum to the forces that have generated an inverted yield curve? If so, what message will the Fed be sending to the markets?
As we write, the two-year Treasury carries a yield that’s four basis points above the 10-year Treasury. Elevating Fed funds up by 25-basis points to 4.75% threatens to increase the inversion by raising the price of short-term money. Indeed, the six-month T-bill is currently 4.80%. Tacking on another 25 basis points would push it over 5.0%.
If there’s any doubt that another 25-basis-point hike is coming next week you won’t find many skeptics in the market for Fed funds futures. The April contract has for some time been priced in anticipation of 4.75%.


Once again, the great question in the halls of bond trading are: what signals, if any, does an inverted yield curve present? More than a few observers have noted that an inverted yield curve can be seen as a harbinger of recession. A New York Fed study published last October, for instance, found that inverted yield curves have a history of presaging economic slowdowns of varying degrees. It’s not a perfect record, but neither is it infrequent.
No matter, as Bernanke devalued such studies in a speech on Monday. Opining at the Economic Club of New York, the Fed chief cast aspersions on the notion that short rates above long ones have any great meaning in the here and now. He offered three reasons. One, interest rates are relatively low compared to previous cases of inverted yield curves, and so any warning signal at present is a shadow of its former self. “This time, both short- and long-term interest rates–in nominal and real terms–are relatively low by historical standards,” he explained.
Two, demand for debt securities is relatively high these days, and so the premium on longer dated bonds is lower, which is bullish for the economic outlook. As he put it, “to the extent that the flattening or inversion of the yield curve is the result of a smaller term premium, the implications for future economic activity are positive rather than negative.”
Third, yield curves are but one variable, and the message dispatched by this measure isn’t entirely consistent with other gauges of economic activity. For example, “the fact that actual and implied volatilities of most financial prices remain subdued suggests that market participants do not harbor significant reservations about the economic outlook,” he argued.
One might wonder what Bernanke is trying to say about the future by diminishing the predictive powers of the inverted yield curve. Yes, it may simply be that the Fed chairman is doing his best to rally the troops and send a message of hope and optimism on matters economic. If so, does it also follow that the path of least resistance for interest rates is upward?
Important questions, to be sure. But they pale in comparison to wondering if the yield curve will stay inverted even after a rate hike next week. If so, what will Bernanke say then? And while we’re at it, how will bond investors react?

One Response to CAN THE INVERTED YIELD CURVE SURVIVE ANOTHER RATE HIKE?

  1. Tom Womack says:

    I can’t help noticing that the yield curve in the UK
    http://newsvote.bbc.co.uk/1/shared/fds/hi/business/market_data/gilt/default.stm
    appears to be quite vigorously inverted, and has been ever since I’ve been looking at it; yields are strictly decreasing from the 15-year out to the 50-year bond. As far as I can tell, this country is not in the depths of a recession.
    Possibly this says something odd about how Britain manages its public finances – panics about ability to fund defined-benefit pensions mean that some institutions feel actuarially obliged to buy 50-year bonds with a yield of 3.8%. Is there no similar kind of issue in the USA?

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