Summary- St. Louis Fed President Bullard is an atypical Fed speaker.
- He argues that the yield curve narrowing will continue under current circumstances.
- He also argues the Fed should consider stopping its rate-hiking policy.
Some Federal Reserve Governors give what I call the "perfunctory" Fed speech: talk about employment and prices from a high level and then issue a vague statement about Fed policy. While I used to dislike outline, I've come to understand that its central purpose is to not spook the markets, which, in the long run, isn't a bad idea. Other Fed governors take a different approach, discussing economic matters from a more academic perspective. I put St. Louis Fed President Bullard into this category; he's always been far more willing to talk about deeper economic topics. Such was the case with his latest speech, in which he discusses the potential for a yield curve inversion in the next 6-12 months and the potential implication for Fed policy inherent in that development.
First off, why all this talk about an inverted yield curve? It has a history of being a very good predictor of recession, as shown in this graphic from Bullard's presentation:
Let's look at the spreads between various maturities, starting with the long-end of the curve
There is almost no difference between the risk of owning a 10-year treasury and a 30-year treasury. The long-end of the curve is almost completely flat.
The 10-year to 2-year spread is also very narrow; it's now below 50 basis points. This is a nearly identical situation to the 30-10 spread.
Then we have the short-end of the curve:
There's still a bit of distance between the 10-year and 3-month treasury. But it's now below 1%.
The short-end has risen about 200 basis points while the 10-year is up 150.
So - what exactly is causing all of this? The short-end of the curve is directly impacted by the Fed's actions. They've been hiking rates pretty consistently for the last 18 months. According to the latest testimony from Fed Chair Powell, that trend will continue:
With a strong job market, inflation close to our objective, and the risks to the outlook roughly balanced, the FOMC believes that - for now - the best way forward is to keep gradually raising the federal funds rate. We are aware that, on the one hand, raising interest rates too slowly may lead to high inflation or financial market excesses. On the other hand, if we raise rates too rapidly, the economy could weaken and inflation could run persistently below our objective. The Committee will continue to weigh a wide range of relevant information when deciding what monetary policy will be appropriate. As always, our actions will depend on the economic outlook, which may change as we receive new data.
But the long-end - which is directly impacted by market forces - hasn't widened. There are several reasons for that. First, inflation expectations - which are an integral component of long-term rates - are very contained:
The 5- and 10-year breakeven inflation rates (which are computed by subtracting the 5- and 10-year TIPS rates from the corresponding Treasury rate) are both at low levels.
And the University of Michigan's consumer inflation expectations has been very consistent over the last 10 years.
Add into this equation the fact that r* - the natural rate of interest - is very low due to low productivity growth, the declining number of people participating in the labor market, and the increased demand for safe assets.
Put all this together, and Bullard makes a compelling argument to stop raising rates soon:
As always, Bullard's comments provide much food for thought.
Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.
I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.