Friday, February 24, 2017

Yield Curve Watch

Here is a scatterplot of the Fed Funds Rate with the slope of the yield curve.  A flat or inverted yield curve is a well-known sign of a coming contraction.  But, the zero lower bound will confound this signal because there is option value in the longer bond maturities, so if short term rates are low, long term rates are less likely to get as low as long term rates.

A very broad review of this relationship suggests that at low rates, a 1% incline is probably, for practical purposes, an inversion.  We were close to this level after the rate hike in late 2015, but something pulled us back up.  If the Fed had hiked earlier in 2016, that might have tipped the scales back down.

As we proceed through 2017, it will be important to watch long term rates.  If they remain low or decline, and if at the same time new data on employment and inflation triggers a new rate hike from the Fed, then that will be bearish.  The 10 year yield is currently about 1.8% above the Fed Funds Rate.

Source

3 comments:

  1. A 10 year rate of 2.4% is all by itself a sign that they are probably too tight. 2% inflation target, so 0.4% real growth (less than population growth). I realize that this formula isn't written in stone, but in the absense of an NGDP futures market, I think a 10 year rate below 3.5% is an indication that I wouldn't ignore.
    Side note: the Fed could (stupidly) invert the yield curve in the past when it moved the Fed funds rate by selling securities from its balance sheet. Today, I wonder. Now that they are moving the Fed funds rate by paying IOR, can they pay more interest out than they are collecting? Uncharted waters.

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