Yield Curve Inversion was Unforced Error

  The Federal Reserve Bank was created 106 years ago to ensure the functioning of the US financial system with the goals of maximum employment, stable prices, and moderate interest rates. These goals are achieved through four mechanisms, but primarily through adjusting various central bank interest rates and the buying and selling of bonds. Over the past decade the Fed has presided over stable prices, full employment and moderate interest rates. However, a new unwritten mandate was created by our Central Bank to anticipate future recessions and tighten credit to regain the ability to ease credit more impactfully when the economy slows. Last December the Fed ignored the falling interest rates, collapsing stock prices and the contracting commodity markets that foretold a slowing economy and decided to raise their Fed Funds bank borrowing rates. That was the primary factor in triggering an inverted yield curve this year with short rates above longer maturities. While the Fed quickly abandoned their misguided forecast for multiple rate hikes in 2019, they have been stuck watching the curve invert more deeply while waiting for signs of economic trouble before they confirm the error of their ways and start cutting rates. We felt at the time the Fed had no inflation risk and should have held rates steady in December at 2 percent and cut rates to 1.75 percent in March to avoid the perception of recession and uncertainty attached to an inverted yield curve. The Fed has been stuck in the naive theoretical Phillips Curve forecast that low unemployment equals high inflation. The outsized concern over inflation has been increasingly replaced by deflation concerns since the 2008 panic and recovery as no amount of money creation or lower level of interest rates have been able to generate expected inflation in Europe, Japan or the US. A Fed Funds rate cut by the end of this July is now 85 percent priced into the futures markets that fear a slowing US economy. While such a cut may be warranted, this expectation seems premature without significant contraction in the economic data or a 2nd quarter GDP report well under 2 percent (report due July 26).

One strong indicator of expanding or slowing Chinese and global economic (GDP) growth trends can be seen in the prognosis from Doctor Copper. The 2011 peak in the red metal coincided with the initial Global rebound from the Great Recession. Copper’s sharp deflation phase in late 2014 and 2015 coincided with the major global energy recession. The late 2016 to early 2018 recovery phase in Copper was indicative of the major GDP growth trends in Europe and the US. Since early 2018 global growth has been slowing, partially due to trade wars, and Dr Copper has been modestly weaker in sympathy. Should Copper break to new lows under $2.60, it would be due to its diagnosis that the China and US trade conflict will cause further economic slowing with growing odds of a recession. We suspect China and the US are not even close to reaching an agreement in the weeks ahead which favors a further drop in Copper and global GDP growth. Copper above $3.00 would temporarily neutralize those recessionary fears.

What does this mean for the yield curve? With all the attention this year to the yield curve inversion fear factor of short term rates above long rates leading to future recessions, we would expect a slower economy to stabilize the curve as the Fed moves into a rate easing phase. Furthermore, the curve inversion is more perspective than reality. As we highlighted in the past, no yield curve inversion has preceded a recession in the US without the 10 year treasury yield being inverted to the two year note. The 10 minus 2’s remain narrow, but still retains a positive yield spread. Even if all Treasury maturities became inverted, the meaning is murky. If the late July report for the 2nd quarter US GDP arrives well under two percent growth, the Fed is more likely to cut short term rates, temporarily reducing inversion fears and feeding the frenzy for even more rate cuts before year end.

Without new trade negotiations between the US and China, we will continue to expect the 10 year Treasury yield to fall under 2 percent in the third quarter. A failure of China’s Xi and President Trump to jump start new trade talks at the end of June G20 summit in Japan, will likely lead to a sharper fall in yields and a temporary drop in stocks in early July. However, stocks may remain buoyant until the Fed meeting and GDP report inflection points over the July 26th to 31st time frame. If the trade war escalates and our GDP falls under a 2 percent growth rate in late July, then stock investor expectations for multiple Fed rate cuts will reach a fever pitch. China trade progress and Federal reserve interest rate direction will remain the pivotal factors to this years market action.




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