Investors have become increasingly concerned about rising US interest rates and the potential for rising inflation. Understanding the factors that influence interests may help to gauge if the economy is heading toward real inflation.
Fixed-income investors consider the US yield curve and yield spreads to be the crystal ball. Not only for alerting them to the future direction of future interest rates but also for pivotal turns in the US economy. When the yield curve steepens, this means the spread between the long-and short-term interest rates widens. A steepening yield curve or widening spreads typically indicates rising interest rates, strengthening economic activities, and rising inflation expectations in the future. On the other hand, a flattening yield curve or tightening spreads warns of lower interest rates, weakening economic conditions, and lower future rates of inflation.
Some believe the shape of the yield curve holds the key to the likelihood of a recession or inflation one year forward. The steepening of the yield curve typically occurs in two ways. First, the long-end rises faster than the short-end, and second, the short-end falls faster than the long-end. The tightening of the yield curve is typically the opposite of the steepening yield curve. The yield curve is the combination of anticipated inflation and the direction of real interest rates.
The Federal Reserve can only influence the short-term interest rates at the early start of the curve. FED has several monetary tools to deploy to influence short-term interest rates – setting the federal funds rate, overnight rates, open market operations, adjusting banks' reserve requirements, etc.
Although FED chairman Powell pledged to not raise interest rates until 2023, some believe the recent acceleration and the steeping of the yield curve may lead to rising inflation, forcing the FED to tighten policy earlier than expected. When the FED increases interest rates, it will begin to impact credit cards, mortgages, and eventually the stock market.
So, are investors correct to fear the steepening of the yield curve will force the FED to tighten monetary policy faster than expected?
From a technical perspective, we note the following about the US yield curve. Contrary to popular opinion, the actual inversion of the US Treasury yield curve does not necessarily signal an economic contraction or the start of a US recession. Rather, only when the spreads of the 10-year yields and the 3-month yields contract to an extreme low (negative spreads) and begin to expand sharply higher (steepens) to an unsustainable high that this triggers a US contraction and the start of a recession.
Since the stock market (SPX) is a leading indicator of US business cycles, it tends to peak in anticipation of an economic contraction and a recession. For instance, when the 10-year minus 3-month yield spreads plummeted to an extreme low of -0.95 (Jan 2000), this did not trigger a recession. It is when the spreads begin to expand sharply higher, reaching historic highs that this led to the tech/telecom 2000-2002 bear market. Again, ahead of the global financial crisis, yield spreads contracted to an extreme low of -0.64 (Feb 2007) before reversing and expanding sharply higher that prompted the 2007-2009 Great Recession.
Nearly two years ago, the yield spreads again fell to an extreme low of -0.52% (Aug 2019), approaching the 2007 bottom (-0.64). The action resulted in the spreads beginning to reverse direction and steepen. The current spreads (1.59) have now cleared above its 10-mo/30-mo ma (1.10/0.46), confirming a monthly golden cross buy signal, and further reaffirming the steepening of the yield spread trend. The breakout above the 2014 downtrend at 0.89, and a new higher-high above the Mar 2020 high (1.16), hints of the next rally to 2.09-2.48 (Jun 2015 and Dec 2016 highs, medium-term), 2.97 (Dec 2013 high, intermediate-term), and then 3.83-3.87 (1992/2004/2008/2010 highs, long-term).
In the three prior spread expansions (steepening of the yield curve), two occurrences led to major U.S. recessions/SPX bear declines (2000-2002 and 2007-2009). However, a third occurrence (2013) resulted in neither a US recession nor an SPX bear decline. Since the yield spreads are far from their historic extreme highs of 3.83-3.87%, does this imply the US treasury yield curve can steepen further before the FED eventually tightens? Also, it is possible the steepening of the yield curve is transitory, like the 2013 scenario, which did not trigger an SPX correction or a US recession.
One final observation, NBER has yet to declare an end to the US recession that began in Feb 2020. It is reported the advance estimate on 4/29/21 that the US real gross domestic product (GDP) has increased at an annual rate of 6.4% during the first quarter of 2021. The GDP has now risen for three consecutive quarters since the bottom in the second quarter of 2020. What will happen when the NBER officially announces an end to Feb 2020?