11-20-17

Michael Collins, the senior investment officer at PGIM Fixed Income, discusses monetary policy. He sees the Fed continuing to be transparent with their plan, which he says will likely result in two rate hikes in 2018. He says that there’s risk of the Fed hiking too much, too quickly, which would flatten the curve and cause a selloff — and possibly even a recession.

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Source X22Report

A Fed Mistake Could Hurtle the Economy into Recession

Source Business Insider

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#economy #recession 

Why this U.S. recession signal is probably throwing off a false alarm

Flatter yield curve says more about Europe and Japan than U.S.

By JEFFRYBARTASH REPORTER

A historic marker used by Wall Street to determine if a recession is coming is flashing red, but there’s probably no need to worry for now about the U.S. economy.

What’s caught the attention of investors is a flattening of the yield curve that usually occurs right before a recession. The last time the yield curve was this flat was 10 years ago, shortly before the onset of the Great Recession.

The yield curve is just a fancy #WallStreet term to describe the difference in interest rates on long-term and short term government Treasurys, in this case the 10-year and 2-year notes.

Investors typically get a higher interest rate for longer-term loans because they take on more risk. They pay a lower rate for debt that matures more rapidly and thus is less risky. Right now the gap between the two rates is unusually narrow.

The flattening yield curve is sure to capture the attention of senior Federal Reserve officials as they lay the groundwork for another rate hike December. On Wednesday, the minutes from the Fed’s last big meeting in October could shed light on their internal debate about what to do next.

In some cases, often right before a recession, the yield curve flattens or inverts. That means investors get the same interest rate or less for a riskier 10-year investment as a safer 2-year investment.

The 10-year yield fell to 2.34% in recent trades, compared to a 1.72% rate on the 2-year note. Why has the yield curve narrowed so much?

Wall Street pros point to aggressive efforts by the central banks of Europe and Japan to buy up government bonds to prop up their economies. That’s left a global shortage of safe, long-term investments, spurring investors to pile into the U.S. 10-year note. Yields fall when demand is high.

The aggressive tactics by Europe and Japan mimic the controversial strategy deployed by the Federal Reserve since 2008 — what’s known as quantitative easing. Yet the Fed is now starting to wind down its own bond purchases because the U.S. economy is healthier now than it’s been in years.

How the Fed responds to flatter yield curve bears close watching. In what is now widely considered a grievous mistake, the central bank kept raising U.S. interest rates in 2006 and 2007 even as the yield curve flattened. A recession soon followed.

Will the Fed repeat the error?

The central bank is on track to raise its benchmark short-term rate in December, and it’s signaled three more rate hikes in 2018. That would bring the so-called fed funds rate to a range of 2% to 2.25%, close to the current rate on the 10-year Treasury.

Yet the Fed is not locked in to its current path. The central bank has repeatedly shown skittishness about raising rates when the economy has occasionally faltered, such as in late 2014.

Lately senior Fed officials are puzzled as to why inflation remains mostly invisible despite an unusually low U.S. unemployment rate and steady economic growth. Inflation typically rises sharply under those conditions.

Dario Perkins, a senior economist at TS Lombard, contends the Fed has effectively outsourced control of when to raise interest rates to bond markets. If so, he argues in a new report, the Fed is unlikely to raise rates as much or as many times as the central bank has indicated.

“This is an odd situation because it suggests central banks are now ‘rate takers’ rather than ‘rate setters,’ ” he wrote. Only a sharp rise in inflation itself or inflation-adjusted bond yields, he added, will force the Fed to be more aggressive.

Yet the passivity of central banks less sure of their own forecasting ability after years of errors also poses risks. So long as interest rates remain low, the potential for deadly financial bubbles remains elevated.

Indeed, some analysts assert the U.S. stock market has soared to record highs in part because of low interest rates. If interest rates were to suddenly spike higher, stocks could take a beating. A similar scenario took place in 1994-1995.

Complicating matters is a pending change in leadership at the Federal Reserve. Chairwoman Janet Yellen’s term ends in February and Fed Governor Jerome Powell has been named as her replacement. Powell is not a trained economist and never worked at the Fed before joining in 2012.

What’s more, the bank’s influential rate-setting Federal Open Market Committee will have been mostly turned over by mid-2018, resulting in one of the least-experienced boards in years.

By some accounts, it could also be more hawkish FOMC, resulting in a Fed perhaps more inclined to raise rates.

Even so, few on Wall Street expect an anxious Fed to suddenly cast aside its go-slow approach. Caution is still the order of the day.

“Whenever policymakers have tried to tighten more forcefully since 2009, they have struggled,” Perkins noted.

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