US Rates Overkill

The US Federal Reserve raised the cash rate (Fed Funds) last night for the 15th successive time. The gap between both US two-year and 10-year bond yields and cash are now closing in on zero. The next meeting of the Fed’s rate-setting committee is on May 10, which could see these spreads go negative as the cash rate reaches 5%.

Now that’s important and new Fed Chairman Ben Bernanke knows it. He told us in 2004 (in What Policymakers Can Learn from Asset Prices) that the “yield curve has turned negative, at least briefly, at between two and six quarters before every US recession since 1964 '¦ It has given only one false signal, in 1966, when an economic slowdown, but not an official recession, followed the inversion of the yield curve” (taken as 10-year rate minus three-month rate).

Further, at the shorter end of the curve, from cash to two-year bonds it rarely goes negative (two-year yield less than cash). In fact for the two-year note there have been only four occasions (using monthly trend data) in the past two decades when its yield dipped below cash (see chart).

On each of those occasions, the Fed cut rates within six months, with most cuts occurring much sooner than that. But last night the Fed predicted “some further [rate rises] may be needed”. Now the market has always led the Fed and should the Fed refuse to follow, by either ceasing rate rises or by not easing, markets may well start to fear interest rate overkill. Interest rate overkill could drive long dated yields lower and take the yield curve further into inversion territory and may cause equity markets to be unnerved.

The shape of the yield curve is still occupying the mind of Bernanke and was the topic for his third speech as Fed chairman last week. But he thinks this time is different and that the current flat yield curve is not “indicating a significant economic slowdown to come”. Instead of a slowdown, he seems to think low long rates reflect investors' confidence in the economy, that all is fine and dandy.

But if that confidence is correct, then what can the Fed see that the markets can’t? Why does the Fed think they have to keep raising rates? From the text of last night’s rate-setting meeting, it would be fear of “inflation”. Last October, after his nomination for chairman was confirmed, I guessed Bernanke would be more hawkish, to answer his critics who said he was soft on “inflation”. It looks as though they may be correct. By bravely ignoring both the market and history, the risk of over-doing rate hikes is growing. Today I would make the same conclusion as I did in October: “If you feared the Fed under Greenspan, you should continue to do so under the new guy; that could be a costly lesson for all of us.”