The yield curve has been on everyone's mind these days. Mostly, will the curve invert, how much and will it project to a recession. History tells us when the curve inverts a recession is likely. The inversion mostly happens when the Fed raises rates too far on the short end of the curve to help stifle inflation that may get out of control.
But the Fed historically has been a staunch inflation fighter. In fact, the record is pretty good for the past 39 years, since Paul Volcker snuffed out double digit inflation. We have never come close to those levels since, and may never will.
To the current situation, the yield curve is flat now, in a few weeks the Fed is likely to raise interest rates for a third time in 2018, bringing the funds rate to 2.25%. They may raise rates one more time this year, but that is on the fence. That is not alarming, as we have seen some inflation coming into the system. Make no mistake, inflation is the enemy of the currency and fixed income, but the Fed has been WANTING this to happen for some time.
But, is inflation out of control and going to force the Fed to raise rates further than expected? Three things tell me no: the 2 yr yield, TIPS and gold. Let's talk about the 2 yr bond, which basically mirrors inflation expectations. We see from the chart the ramp up in this yield over the past year to 2% plus. However, Friday’s job report showed an increase in wages, and the yield rose up to multi year highs.
This is a good situation for the Fed right now and the economy, for them to take back the generous accommodation since the financial crisis, and for the economy to grow with little inflation.
Notice the chart of TIPs, or inflation-protected securities. These instruments peg the CPI (consumer price index), and will rise when inflation rises. These bonds are not running out of control, hence inflation is contained.
Lastly, gold is floundering around 1200 an ounce. Historically, gold has been an inflation hedge, against the dollar. That has not occurred here, and frankly there is more interest in dollars than the relic metal (due to economic strength in the US).
So, we have a good situation here - but it requires constant monitoring, the Fed is focused on the data. As should we!
