US Fed Rates and Yield Curve Concerns

Updated: Dec 23, 2019

Today on 13th June 2018, Fed Chairman Jerome Powell is expected to hike the overnight rate by 25 basis points, taking it to around 2%. While Fed has been periodically rising rates over past year or so, this time the investor community is concerned more than before.

Their fear is not newfound. Investors globally keenly watch the US treasuries yield curve when it inverts, as it is a proven precursor to incoming recession. Yield curve is called Inverted when the short term LIBOR rates (e.g. 3 months) are more than long term treasury bond rates (10Yr/ 20Yr/ 30Yr). When that happens, investors start moving money from long term bonds to short term lending instruments. One of the consequences is – a recession in financial markets that follows within 12 to 18 months. And when recession hits USA, it hits the world. Always.

This phenomenon was observed practically in every recession that happened in past 100 years. Most notably – the yield curves inverted in the beginning of February 2000, and then again in February 2007. We know the history – 2001 was a terrible year for stock market, starting first with dotcom meltdown, followed by longer recession after 9/11. And what happened in 2008 is a very recent history. The governments had to pump massive amounts of money to prevent many banks from going belly up.

Today the yield curve looks like this –

On the left side is the yield curve today. The overnight LIBOR is barely 1.71%, and it keeps up pace with Fed rate. As the rate goes up to 2%, it will hit the same mark too. However the yields of 10 yr Note and 30Yr bond, which are 2.94% and 3.02% respectively, are not expected to go up in the same quantum.

Now this rate hike would not necessarily invert the curve. Yet, we are expecting one or two more hikes before end of 2018, and possibly a few more during 2019. And that can change the shape of the curve completely. And that is the cause of concern.

Whether it happens or not, only time will tell. We must have the plan B, should the recession happen. The yield curve signal will give sufficient lead time to move monies from one asset class to another. There will be another blog post discussing this. Stay tuned.

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