The Inversion Aversion

Most of 2018 played out according to plan in the bond market. Early in the year market strategist expected faster U.S. economic growth, higher inflation and a Federal Reserve that might be “behind the curve” in its efforts to head off inflation via higher interest rates. Tax cuts, healthy job growth and high consumer confidence buoyed stock prices and long-term interest rates through the summer and into the early fall. The Fed kept pace as well, pushing up short-term rates 4 times during the year.

Economists are generally a “glass half empty” bunch, however, and many had been looking for a reason to downgrade the outlook throughout the year. THey got their wish in late October, when weakening overseas economic growth, a tariff war with China and concerns about a (now) over-aggressive Fed conspired to knock markets for a loop. THese forces caused a flight to quality – away from riskier assets and into Treasury bonds. Long-term interest rates plunged. Events accelerated in November, as the reality of a new and more combative Congress was priced in. By year end, rates on the 10-year Treasury bond had fallen by over half a point, from 3.23 percent at peak in November, down to 2.68 percent.

This was about a quarter point higher than where they began the year (2.40 percent), but the small increase for 2018 rings hollow. Rates had reached a seven-year high just 8 weeks earlier! Investors wondered how all the “work” of moving long-term interest rates back toward historically normal levels could’ve been erased so quickly.

More importantly, this drop in long-term rates, when combined with ongoing Fed increases in short rates, meant the spread between short and long rates had shrunk to very low levels. For example, the difference between the 10-year rate and the 2-year rate had fallen to just 18/100 of a percent by year end. Historically, this level of spread tightening has been associated with economic slowdowns, and absolute inversions of these two rates (with long rates below short rates) have nearly always signaled recession. Currently the spread remains positive, so we do not believe a recession is imminent, but an extended invasion could mean one is on the way.

As the chart below shows, 7 of the last 9 ties that interest rates have inverted, we were in a recession soon afterward.

Given these conditions, monetary policy makers on the Federal Reserve board must act with extreme care. They raised short term rates 4 times in 2018, as expected. The path forward gets trickier. Recent comments from board members indicate we may be closer to the end of the rate tightening cycle than the beginning. When the Fed began this cycle back in December of 2015, we believed the Fed Funds rate could eventually rise well above 3 percent. Today this seems unlikely. The current prescribed range of 2.25 percent to 2.50 percent – combined with an active stock market – makes us think we will see at most one more hike in 2019.