Minneapolis Federal Reserve President Neel Kashkari believes “This time is different” are the four most dangerous words in economics. Writing on 16 July, Kashkari said that the Fed should pause its rate hiking cycle, so as not to invert the yield curve and risk triggering a recession.
An inverted yield curve, where short-term rates rise above long-term rates, is typically seen as a signal of an impending recession, and Kashkari believes there is little reason to think this time is different. But, in our view, it is more important for investors to watch Fed policy and the growth data itself than the yield curve.
- An inverted yield curve lacks useful predictive power. Since 1988, an inverted 2-year/10-year yield curve has preceded the start of US recessions by as few as 150 and as many as 750 days. There is also reason to believe it is becoming an even less useful indicator today, with institutional demand for long-term assets unrelated to the short-term business cycle, suppressing term premia.
- An overheating US economy appears to be as much a risk as a recession. For example, monthly net job gains averaged more than 200,000 in the first half and growth in manufacturing jobs is at its highest level since 1998. Wage growth remains contained, but the risk is that a tight labor market feeds through to wage inflation.
- Fed Chair Jerome Powell is likely to present a more balanced view at his testimony to the Senate Banking Committee today. In June, Powell said that yield curve flattening makes “all the sense in the world” as short-term rates increase.
We expect the Fed to continue on its gradual tightening path, raising rates at a pace of 25 basis points per quarter for the rest of this year. Rather than the shape of the yield curve, we will be looking for signs that Powell sees rising risks to growth from escalating trade tensions. We are overweight equities but remain watchful, and hold counter-cyclical positions in US Treasuries and equity put options.
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