When Doves Fly - March 25, 2019

Wednesday’s Fed meeting had four big takeaways. The Fed is projecting no rate hikes this year, down from two at the December meeting. And the Fed will end the runoff of its balance sheet in September, a little earlier than most had anticipated. The dovish tilt that began in January continues.

In addition, the Fed kept its key rate at 2.25-2.50% as expected. Finally, Fed Chief Jerome Powell says he expects “solid growth” this year, though the Fed downgraded the economic outlook.

While the Fed says it wants to maintain today’s rates, investors are trying to sniff out a rate cut this year amid the slowdown in the global economy and its possible impact at home.

Take a look at Figure 1. As of March 22, investors were pricing in more than a 50% chance of at least one rate cut this year and a 43.7% chance rates will remain unchanged.

On March 14, the odds the Fed would hold rates at the current level were nearly 80% (CME Group). Yes, sentiment can change quickly. It’s not that a rate hike won’t occur this year. The global and U.S. economy could rebound. But the hurdle for an increase is high right now.

At his press conference, Powell pushed back on any talk of a rate cut, arguing he believes one isn’t needed.

A kink in the curve

The only question at the press conference about the yield curve was related to the Fed’s shift on the balance sheet, not specific concerns about whether a flat or inverted yield curve might be a more ominous economic signal. In recent days, however, we have begun to see a “kink,” or partial inversion in the yield curve. We are not seeing a complete inversion, where short-dated maturities yield more than long-dated maturities.

Figure 2 plots Treasury yields from 1 month to 30 years and compares the March 22 curve with March 1. The all-important 2-year remains below the 10-year, but the one-month and 3-month bills are yielding more than the 10-year.

It’s not that recession is imminent. In fact, looking back at the last five recessions, it took an average of 20 months for a recession to ensue following the inversion of the 10-year – 2-year (St. Louis Federal Reserve, NBER). Moreover, U.S. data last week was encouraging, including a big increase in existing home sales (Natl Assoc of Realtors) – thank lower mortgage rates – and a rise in Conference Board’s Leading Index.

But an inverted curve has typically been a leading indicator of a recession. In part, banks usually begin to restrict lending. In part, it is the bond market’s signal the economy could eventually weaken.

A near-term surprise cut by the Fed would bring yields down at the short end of the curve, reducing odds the curve completely inverts.

Historically, recessions have ensued when the Fed drives rates too high in response to inflation, or economic imbalances lead to an economic downturn. Neither are big concerns today.