FOMC Fears about the Yield Curve08.09.2018
Earlier this summer, FOMC members voiced concerns about the ongoing flattening of the Treasury curve. A few members even indicated that further meaningful compression of the difference between long and short Treasury yields – which would increase the potential for the yield curve to invert – could be grounds for altering or pausing the Fed’s tightening cycle.
Currently, there’s no consensus among Fed officials about the severity of this trend. Lael Brainard, a member of the U.S. Federal Reserve's Board of Governors; William C. Dudley, New York Fed president; and Loretta Mester, Cleveland Fed president; are focusing on other factors. These include the size of the Fed’s balance sheet, which has compressed the term premium (the difference between long and short rates).
Other officials, such as Raphael Bostic, Atlanta Fed president; James Bullard, St. Louis Fed president; and Robert Kaplan, Dallas Fed president; have spoken of their hesitancy about inverting the curve. Somewhere between these extremes, John Williams, San Francisco Fed president; said the yield curve shape should be watched closely, though he expects long rates to rise, delaying an inversion.
The May FOMC meeting minutes highlighted the range of views on this topic and noted several potential causes of this flattening, such as:
“…the expected gradual rise of the federal funds rate, the downward pressure on term premiums from the Federal Reserve’s still-large balance sheet as well as asset purchase programs by other central banks, and a reduction in investors’ estimates of the longer-run neutral real Fed Funds rate.”
Worries about curve flattening and possible curve inversion are understandable. The yield curve slope has a long history of acting as a reliable predictor of upcoming growth slowdowns, particularly recessions.
In reality, the yield curve has inverted around every recession over the past several decades (see chart below). This relationship may hold for a number of reasons, including the forward-looking nature of interest rates. Interest rates may help to anticipate future growth dynamics, such as a flatter yield curve reducing the incentive for credit union and bank lending activity, which, in turn, may slow growth.
The FOMC has reasons to be more concerned about the potential for a recession and curve inversion in the current environment. FOMC policy is likely to be less effective in supporting the economy in response to the next downturn. With the Fed Funds rate still near historically low levels, the zero lower bound is likely to become a binding constraint when the next downturn occurs. Additionally, the Federal Reserve balance sheet policy (Quantitative Easing) may be more constrained due to the higher level of central bank securities holdings. Lastly, fiscal policy could be more constrained because of rising and above-average government debt levels. As a result, the next downturn could be more severe than it otherwise would be if monetary and fiscal policies were as unrestrained as in the past.
Fed concerns have merit relative to past cycles; however, the predictive power of the yield curve has diminished, making the FOMC’s worries about its slope puzzling. Policymakers have undertaken a number of measures that have, intentionally or unintentionally, put downward pressure on longer-term Treasury yield premium or, at least, limited the curve steepening.
What Has Kept the Curve from Steepening
Larger Federal Reserve Balance Sheet
Unwinding the Federal Reserve’s larger-than-normal balance sheet is perhaps one of the most important factors preventing the curve from steepening. The Fed chose to unwind its balance sheet in a very gradual manner, using a segmented cap structure. This implied that no more than $60 billion in Treasuries and mortgage-backed securities would roll off in the first quarter of 2018 and that the balance sheet would decrease by no more than $90 billion in the second quarter.
By the Fed staff’s own estimates, the balance sheet continues to put significant downward pressure on longer-dated term yield premiums. For example, the most recently published median estimate indicates the Fed’s balance sheet is still compressing the 2-to-10 year term premium by almost 60 basis points in the current quarter.
Forward Guidance by the FOMC
The second factor that has helped flatten the yield curve is the FOMC’s forward guidance and communication. As noted in the minutes, the market’s expectation for gradual rate hikes and pricing of a lower equilibrium rate have contributed to the flatter curve. Agreement that the Fed should continue with “gradual” rate hikes has become nearly unanimous within the FOMC, a fact reinforced frequently in FOMC communications. This language, along with the continued presence of the FOMC’s steadily declining dot plot, contributes to greater certainty about the future path for the Fed Funds rate and, likely, a lower risk premium for holding bonds. Estimates from key FOMC members (Holston, Williams and Laubach) reinforce this view, along with the steady decline in the long-run dot plot in the Fed’s economic projections.
Monetary Policy has Been Accommodative to Risk Assets
The support that accommodative monetary policies provide to risk assets is another factor keeping the curve flat. In particular, stock market outperformance has led to large flows into Treasury bonds from pension funds and others, as these funds seek to lock in equity gains and re-balance their portfolios. These fixed income inflows into longer Treasuries in search of yield have contributed to term premium compression pressures. To the extent that the equity market’s strong performance is partially driven by global central bank balance sheet expansion and continued low policy rates, central bank policies have added further downward pressure on the yield curve slope.
Shorter Term Treasury Issuance
In addition to monetary policy measures, the FOMC has another tool that limits the extent of longer-term premium normalization, or curve steepening. Treasury issuance is likely to skew toward shorter maturities. For example, the 12-month average share of net issuance of Treasury bills rose to a post-crisis high in March 2018 and in April, remained at its third highest level since the last recession. While this rise was partly attributed to the Treasury replenishing its coffers after resolution of the debt ceiling, coupon issuance in 2018 is likely to continue to tilt toward shorter maturities.
Based on announced issuance through July 2018 and expectations for the remainder of the year, the share of shorter maturities (i.e., 2-year and 3-year) is set to rise in 2018, while the share of longer maturities (i.e., 10-year and 30-year) is expected to fall slightly.
There are fundamental reasons for the yield curve flattening, and the FOMC should be vigilant of a narrower slope driven by these factors. FOMC rate hikes almost always flatten the curve. This dynamic is accentuated during the current cycle due to expectations that the neutral Fed Funds rate is considerably lower than in the past. The yield curve would also be significantly steeper in the absence of the factors discussed above.
A steeper curve could alleviate some of the concern about a slow-down signal for forward-looking growth prospects. It would also undoubtedly weigh on near-term growth prospects by tightening financial conditions through higher term premiums and weaker risk assets. In this context, the policies from the Fed and other institutions have created a favorable outcome. They have contributed to low, longer-dated term premium, a flatter curve and easier financial conditions, which have supported growth, strengthened the labor market and allowed inflation to return to near the Fed’s target.