Will the Fed Yield to the Yield Curve?

Will they or won’t they? With the U.S. yield curve flattening to new cycle lows, whether or not the Federal Reserve will stick to its planned rate-hike path is a key question – and could soon become the key question – for financial markets.

It is well-known that an inverted yield curve, as measured by the spread between 3-month Libor and 10-year Treasury interest rates, has been a reliable leading indicator of recessions over the past 50 years. To be sure, the 3-month Libor to 10-year spread is still positive at around 50 basis points currently. However, unless 10-year yields rise, the curve could invert by year-end if the Fed hikes rates another two times, as suggested by its own dot plot. So will Fed officials ignore a potential curve inversion and keep raising short rates beyond that point, or will they pause and adjust their forward guidance to avoid a lasting inversion?

The Fed’s semi-annual Monetary Policy Report to Congress issued on 13 July remained silent on this question. However, it repeated the language that Fed watchers can recite while sleeping:“The FOMC expects that further gradual increases in the target range for the federal funds rate will be consistent with a sustained expansion of economic activity, strong labor market conditions, and inflation near the Committee’s symmetric 2 percent objective over the medium term.”

Finding neutral

So how many “further gradual increases” should we expect? A reasonable assumption would seem to be that, provided the economic backdrop cited above doesn’t change radically, the Fed will raise rates until the fed funds rate reaches the neutral rate, defined as a level of rates that keeps the economy growing on trend and inflation on target over the medium term. OK, sounds good in theory, you may say, but where is neutral?