The yield curve is rapidly approaching a flat state in response to anticipated Fed hikes.
Both the 7-year note and the 10-year note yield 1.98%. The 5-year note lags by a mere 8 basis points (.08 percentage points).
The curve is inverted (downward sloping), between 20 and 30 year durations.
Yield Curve Spreads
The yield curve has been flattening since March 2021 in response to anticipated rate hikes.
The 2-10 spread has fallen from 1.59 percentage points to 0.40 percentage points.
Economists watch this spread because when it inverts (a shorter duration bond yields more than a longer term bond) it’s a recession signal. If the Fed hikes 50 basis points (a half point hike), the curve might easily invert.
Note the 20-year to 30-year spread is already inverted by 6 basis points. This corresponds to the downward slope in the lead chart.
Flattening Concerns
This flattening is a sign the economy is weakening even as inflation has been ramping up.
It’s a difficult environment for banks and borrowers alike and because inversions morph into recessions.
Fed Credibility on the Line
On February 14, St. Louis Fed president James Bullard gave an interview with CNBC in which he discussed rate hikes and the Fed’s inflation credibility.
I commented on that in James Bullard Says Fed Credibility Is On the Line, Repeats Faster Rate Hike Message
Bullard Statements
- We have the hot CPI report. Not so much that report alone, but the last four reports taken in tandem have indicated inflation is broadening and possibly accelerating.
- I am just one person but I would like to see 100 basis points on the policy rate by July 1.
- “I do think we need to front-load more of our planned removal of accommodation than we would have previously. We’ve been surprised to the upside on inflation.
- This is a lot of inflation in the US economy. 7.5% on the headline CPI. These are numbers Alan Greenspan never saw and haven’t occurred in 40 years.
- Our credibility is on the line and we do have to react to data.
- I think the inflation we are seeing is very bad for low and moderate-income households. Real wages are declining. People are unhappy. Consumer confidence is declining. This is not a good situation.
Balance Sheet Runoff
The DailyFX reported this comment by Bullard: “From balance sheet run-off, I’d want to see the yield curve steepen.”
Kansas City Fed President Esther George commented on the balance sheet in her speech on January 31, 2022, The Economic Outlook and Monetary Policy
- All in all, it could be appropriate to move earlier on the balance sheet relative to the last tightening cycle.
- While it might be tempting to err on the side of caution, the potential costs associated with an excessively large balance sheet should not be ignored.
- A large Fed presence in markets can displace private activity, even in a market as large and liquid as that for U.S. Treasuries and certainly where the central bank holds roughly 1/4 of the MBS market. This presence can distort price signals, currently most evident in the pricing of duration. By holding long duration assets, the Fed’s balance sheet is depressing the price of duration, by lowering longer-term yields by as much as 1.5 percentage points according to some rules-of-thumb, incentivizing reach-for-yield behavior and increasing fragility within the financial system.
- Second, and related, maintaining a large balance sheet reduces available policy space in the inevitable next downturn.
- Finally, a large balance sheet has the potential to intertwine fiscal and monetary policy in the public’s eyes and could unintentionally pose risks to the Fed’s independence and authority. In a rising rate environment, this risk could become more apparent as interest paid on the large stock of reserve liabilities grows.
Free Money to Banks
Pay particular attention to that last bullet point by Esther George. She is discussing free money the Fed hands out to banks at taxpayer expense.
Sweet Deal for Banks
The Fed currently pays banks 0.15% interest on reserves.
With QE at $8.9 trillion dollars, banks annually collect $13,350,000,000 interest annually on free money (QE) the Fed crammed down their throats.
This has been going since former Fed Chair Ben Bernanke lobbied Congress for the right to pay banks money on excess reserves. The Fed then reduced the reserve requirement to zero, making all reserves excess reserves, now simply called reserves.
I suspect interest the Fed pays on reserves will rise in March, possibly to 0.40% or higher when it hikes in March. On a double hike by 50 basis points, the Fed might pas as much as 0.60% interest on reserves.
Since the Fed has no intention of winding down its balance sheet, the 0.40% interest rate would allow banks to collect $35,600,000,000 a year in “free” money.
It’s not really free, of course. You and I (taxpayers) foot this bill.
Fed’s Balance Sheet
That balance sheet amazingly enough is still expanding. In the last week, the Fed added another $5 billion.
The Fed’s total balance sheet is nearly $8.9 trillion.
Emergency “Sunshine” Meeting
The Fed had an Emergency Sunshine Meeting on Monday, the following matters: “Review and determination by the Board of Governors of the advance and discount rates to be charged by the Federal Reserve Banks.”
They are concerned about QE, reversing QE, and interest rates on excess reserves.
Some expected the Fed to hike intra-meeting but the Fed only does emergency cuts, not hikes.
There was zero sunshine at the meeting or following it.
Too Late For Honesty
All of a sudden we are getting a little bit of honesty from Bullard on how Fed-sponsored inflation has been “very bad for low and moderate-income households.”
We also see Esther George discussing three issues regarding the Fed’s balance sheet.
We should have had dissents for at least the past 6 months on rate hikes. The Fed should have stopped balance sheet expansion (QE) as soon as it as clear the economy was recovering. Better yet, there was no good excuse for QE in the first place.
Now What?
- The economy is slowing
- The Fed is about to initiate a rate hike cycle
- The yield curve is flattening before the rate hike cycle has even started
- Inversions and a recession are on the horizon
Delusional Bullard
Bullard is hoping that Quantitative Tightening (QT), the opposite of QE coupled with rate hikes will steepen the curve.
If he really believes that’s likely, he is delusional. The normal response to tightening is a flattening of the curve. Yet Bullard is a proponent of more aggressive hikes.
It’s far more likely, we will see the Fed panic after two or three hikes and never start QT at all.
Ironically, the Fed doing nothing and letting inflation run hotter would steepen the curve.
This post originated at MishTalk.Com.
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accommodation than we would have previously. We’ve been surprised to the
upside on inflation.”