Flat yield curve suggests Fed rate hikes make be ill advised

Jerome
Powell testifies before the Senate Banking, Housing and Urban
Affairs Committee on his nomination to become chairman of the
U.S. Federal Reserve in Washington, U.S., November 28,
2017.
Joshua
Roberts/Reuters

• The flat yield curve suggests investors are not as
  convinced as Federal Reserve officials about their ability to
  continue raising interest rates without harming the
  economy. 
• Steve Blitz of TS Lombard says what really matters for
  bank lending is the gap between the federal funds rate and the
  two-year note, which has been widening.  
• St. Louis Fed’s Bullard: “What
  we could do is take signals from financial markets that are
  telling us that we’re about where we need to be right
  now.”

Look no further than the $15 trillion US government bond
market for evidence investors are not convinced the Federal
Reserve can keep raising interest rates at the recent clip
without derailing the economy,

The Fed is widely expected to raise the official federal
funds rate by another quarter percentage point later this month,
bringing its ceiling to 2.25%. It has been raising rates
predictably by a quarter percentage point every three months,
when Fed Chair Jerome Powell holds his post-meeting press
conferences.

Yet the ongoing compression of long- and short-term
Treasury bond yields, known as a
yield curve flattening, is not only a traditionally-reliable
harbinger of recessions, but also arguably a contributor to
economic downturns. 

“Talk of the flatter yield curve
presaging recession continues to run rampant among the
chattering classes,”
Steve Blitz, chief US economist
at TS Lombard, wrote in a research note.

And it’s not just the more closely-watched yield gaps, like
the spread between 10- and two-year notes.

What counts is not whether the curve is flat but whether
it’s negative, and the negative curve that counts most is the
spread between the yield on two-year Treasury notes and the
federal funds rate, Blitz writes.

“We have long made the point that the shape of the curve is
not a talisman. It works because when short-term money earns more
than lending, the flow of loanable funds moves away from
credit.”

The chart below shows that when the two-year Treasury note
starts to yield less than the funds rate, “banks begin to tighten
credit standards for commercial loans to mid-sized and large
firms (identified by the circled areas). Not surprisingly,
recession begins soon after.”

That particular curve has actually been steepening since
last summer, says Blitz, and the percentage of banks tightening
credit standards has shrunk in line with historical norms.

TS
Lombard

James Bullard, president of the St. Louis Fed, thinks the
central bank should heed the age-old message of the yield curve
and hold back on further interest rate increases until further
notice.

“We’ve already been preemptive,” he told Fox Business this
week, according to transcripts of the interview. “We raised rates
while the inflation rate was below our target. We started
shrinking the size of the balance sheet before inflation came up
to target. So we’ve done these things over the last two years.
Now we’re in pretty good shape and I think what we could do is
take signals from financial markets that are telling us that
we’re about where we need to be right now.”

In particular, Bullard pointed to one thing: a “very flat”
yield curve.

“I’d rather not see an inverted yield curve in the US
That’s usually a harbinger of a slowdown ahead. And inflation
expectations, based on market based measures, are low and remain
right around our target. I think it shows that we’ve got a pretty
good policy right now and we should stay where we are and see how
the data come in.”

Atlanta Fed