Wall Street recession gauge flashing yellow, not everyone says it’s a false alarm

Federal
Reserve Chairman Jerome Powell speaks following the Federal Open
Market Committee meeting in Washington.
Carolyn Kaster/AP

• Federal Reserve Chairman Jerome Powell has argued the
  narrowing gap between long- and short-term borrowing costs is
  nothing to worry about.
• Some of his colleagues, including St. Louis Fed
  President James Bullard and Minneapolis Fed President Neel
  Kashkari, disagree.
• “Yield curve inversion is a naturally bearish signal
  for the economy,” Bullard said, warning about the prospect that
  long-term rates will slip beneath long-term ones. “This
  deserves market and policymaker attention.”

Federal Reserve Chairman Jerome Powell has
downplayed a persistent market trend that tends to worry
investors about the prospect of an oncoming recession, saying
special factors are to blame for a recent narrowing of the gap
between long- and short-term interest rates. 

But not everyone at the US central bank is so sanguine about the
so-called flattening of the yield curve, which many economists
believe will lead to an outright inversion — where long-term
rates slip beneath their short-dated counterparts.

“There is a material risk of yield curve inversion over the
forecast horizon (about 2 ½ years) if the FOMC continues on its
present course,” James Bullard, President of the St. Louis Fed,
said in
a presentation delivered in Scotland.
The
Federal Open Market Committee has raised interest rates several
times since December 2015, bringing official borrowing costs to a
range of between 1.75% and 2%. 

“Yield curve inversion is a naturally bearish signal for
the economy,” Bullard said.  “This deserves market and
policymaker attention.
The risks of yield curve
inversion are best avoided by FOMC caution in raising the policy
rate during 2018.”

The gap between 10- and 2-year Treasury note yields has
recently narrowed to around a quarter percentage point, the
smallest gap since just before the last financial crisis.

St. Louis
Fed

Bullard is not alone. Minneapolis Fed President Neel Kashkari

is also warning about the perils of ignoring historically
reliable signals sent by the yield curve.

Low long-term interest rates point to a market expectation of low
investment returns, and are thus a harbinger of weak economic
growth.

“If the Fed continues raising rates, we risk not only
inverting the yield curve, but also moving to a contractionary
policy stance and putting the brakes on the economy, which the
markets are indicating is at this point unnecessary,”
Kashkari wrote. “Deciphering the many signals from financial
markets is not an exact science. But declarations that “this time
is different” should be a warning that history might be about to
repeat itself.”

Tim Duy, economics professor at the University of Oregon and an
avid Fed watcher, writes in his blog that the dangers of an
inverted yield curve might not be evident at first, allowing the
Fed to keep raising rates and potentially deepening an eventual
downturn.

“It is now easy to see the 10-2 spread inverting by then
end of the year, an event that has traditionally been the
harbinger of recession,” Duy writes in his blog,
Tim Duy’s Fed Watch. 

“
An inversion would certainly raise my
attention with regards to the possibility of recession, but be
careful on the timing,” he added.

“The 10-2 spread is a long leading indicator. The earth
will not shake when that spread inverts. There will not be a
plague of frogs. Blood will not rain from the sky. From the
perspective of policy makers, the lack of immediate economic
implication means it can be easily dismissed. And in my opinion
that dismissal is the soil in which the seeds of the next
recession are sown.”

St. Louis
Fed