The Yield Curve Inverted Months Earlier Than Most Think by John Mauldin
- It appears the yield curve was “inverted” back at last December, but we just didn’t know it.
- The Powell Fed spent 2018 gradually raising rates and reducing the balance sheet assets. And this amounted to an additional tightening.
- If we assume every $200B balance sheet reduction is equivalent to another 0.25% rate increase then the curve effectively inverted months earlier than most now think.
- The Fed has always been behind the curve. To Powell’s credit, he may be trying to get in front of it, at least this time.
The inverted yield curve is one of the more reliable recession indicators.
I discussed it at length last December. At that point, we had not yet seen a full inversion. Now we have, and it appears the curve was “inverted” back then, and we just didn’t know it.
The Powell Fed spent 2018 gradually raising rates and reducing the balance sheet assets it had accumulated in the QE years.
This amounted to an additional tightening. In fact, the balance sheet reduction may have had more impact than lower rates.
Now if you assume, as Morgan Stanley does, every $200B balance sheet reduction is equivalent to another 0.25% rate increase, which I think is reasonable, then the curve effectively inverted months earlier than most now think.
Worse, the tightening from peak QE back in 2015 was far more aggressive and faster than we realized.
Let’s go to the chart below. The light blue line is an adjusted yield curve based on the assumptions just described.
Source: Morgan Stanley
But even the nominal yield curve shows a disturbingly high recession probability. Earlier this month, the New York Fed’s model showed a 33% chance of recession in the next year.
Source: New York Fed
Their next update should show those odds somewhat lower as the Fed seems intent on cutting short-term rates while other concerns raise long-term rates.
But it’s still too high for comfort, in my view.
But note that whenever the probability reached the 33% range (the only exception was 1968), we were either already in a recession or about to enter one.
For what it’s worth, I think Fed officials look at their own chart above and worry. That’s why more rate cuts won’t be surprising.
And frankly, and I know this is out of consensus, I would not rule out “preemptive quantitative easing” if the economy looks soft ahead of the election next year. Just saying…
But that’s not everyone’s view.
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