Yesterday, the US yield curve became inverted. The yield on three-year Treasuries was temporarily (blink and you’ll miss it) lower than that of their two-year counterparts. This is, apparently, huge.
Many are worried because an inverted yield curve has frequently been a sign of upcoming recession. And though commentators typically look at other spreads (usually ten-year over two-year), this is the first part of the curve to become inverted for some time and could suggest a need for rates to be cut in the relatively near term.
However, as always, we cannot simply take an indicator, metric or data point as our lead. We need to step back and consider why they matter. How much does the policy rate influence the real economy and does a 0.25% change influence an individual’s decision to borrow, or a company’s decision to invest?
These are the questions that the Fed and markets must ask themselves. They are after all the reasons that policy rates are moved at all.
The real economy
Understanding the transmission mechanism from a change in the policy rate to the actions of the individuals and institutions, is always complex and always changing. Richard Woolnough has written in the past about how conditions can tighten without the Fed lifting a finger. We have also written about the dangers of an obsessive belief in the ability of the Federal reserve to fine-tune the economy.
There can clearly be more important developments than small changes in the official policy rate. For example, here is what has changed in the last couple of months:
There has indeed been a decline in beliefs about how far the Fed will have to tighten in the near term. The market implied path of policy rates (using the forward curve) still suggests a greater likelihood than not of a rate increase at the December meeting, but compared to what was priced in at the end of September, there seems to be a belief that we are less likely to have seen as many increases by Q3 next year.
The inversion in yields from two to three years also clearly implies that there is not an insignificant chance the Fed will have to ease in the next few years. In both cases however, the change is modest.
In contrast, credit markets saw relatively profound moves in October.
These aggregates suggest that between September and November, the borrowing costs of the US corporate sector have increased by over one percent for high yield companies, and 25 basis points for investment grade companies (approximately the same amount that the 2-Year/3-Year spread has fallen).
Over a longer period, individual consumers have also seen a tightening. Jim Leaviss has noted recent reduced activity in the housing and car markets in the US. Yesterday, the New York Fed released its latest credit conditions survey and observed on tightening conditions.
These types of development, are of course exactly why the Fed would want to tighten in policy in the first place. And if they are already taking place, the need to tighten policy is clearly reduced; it may be that we have simply exchanged one form of tightening for another.
The real economy, and the market
It may seem odd that we have written so often about the Fed and the yield curve on this blog, when we often seem to be suggesting that they are nothing to worry about.
The reasons for this are two-fold. First, while the impact of the Fed on the real economy seems very often to be overstated, the impact on markets is not. Our belief is that much of market behaviour this year can be explained by the role of US short rates insofar as they reflect a global discount rate. Understanding these issues is a central consideration for assessing asset prices.
Second, we are not denying that it is possible for either the Fed, or market moves themselves, to tighten conditions beyond what the ‘real economy’ can handle. This matters for the ordinary lives of men and women globally and, less importantly, for investors. ‘Backing value’ in assets like equities involves having a sense of future earnings streams and policy error can invalidate this even over longer time horizons. Recessions can mean you lose significant amounts of money no matter how cheap you thought your assets were.
What we question is the obsessive focus on single issues like Fed policy, or on particular metrics without apparent consideration of what lies behind them. We must play close attention to such variables, but not at the expense of all else.