ORLANDO, Fla. - Dec 14, Reuters -- If it is true that the U.S. economic expansions never die of old age but are murdered by the Federal Reserve, as Ben Bernanke once observed, the yield curve is the most important piece of evidence in most cases.
Bernanke's quip about three years ago, echoing German economist and MIT professor Rudi Dornbusch, comes to mind as the Fed prepares to raise interest rates against a backdrop of a flattening yield curve.
This trend across the curve reminds of the fact that the recession is on the horizon and closer to view. It is still years away and will not be an issue in 2022, according to analysis of previous tightening cycles.
The Fed is worried that it has to jack up borrowing costs aggressively in order to tame inflation. In this scenario, the recession could become an issue very quickly.
Economists at Deutsche Bank note that 13 Fed rate-hiking cycles have lasted just over two years since 1955. The recession has historically followed three to three to three and a half years after the first hike or liftoff. The range between the shortest and the longest gaps is huge. The 1980 hikes were just 11 months later, while the next recession after the 1983 hikes was not until 1990, a period of 86 months.
The Deutsche Bank research shows that the 2 s 10 s yield curve starts at an average level of 100 basis points at the first rate hike and flattens by 83 basis points in the first year after the hiking cycles begin.
This means that the Fed hikes are close to flat for the first year in a row. The curve has inverted a year later in six of the 13 tightening cycles, with the recession normally following around 18 months after that.
Most economists agree that the inversion of the two and 10 year Treasury yields is as good a warning as any of the upcoming recession risks. It has preceded all six recessions of the past 40 years.
The gap between the two is currently 77 basis points, so it is still some way from inverting. In May, it was double that, and since then annual inflation has risen to its highest in almost 40 years, and the Fed policymakers, including Chair Jerome Powell, have turned varying degrees of hawkish.
The Deutsche Bank economists note that soft landings are very difficult to achieve, and more so the central banks are behind the curve because of the fact that recessions are very difficult to predict. Economists at the Bank of America agree that recessions always come well after the onset of tightening cycles. They point out that other shocks are often a contributing factor, such as the tech bubble bursting in 2000, and the global credit crunch in 2008.
Economic contractions come pretty soon after the tightening cycle has ended, as shown by the last 40 years. How long will the cycle last?
The current market pricing has it beginning in mid- 2022 and likely extends through the end of 2024. Economists at Barclays predict nine quarter-percentage points will be increased in total, and economists at UBS expect 10.
This timeline coincides with a rare inversion in the Eurodollar futures market around the late 2024 and early 2025 part of the curve. Jeff Snider, the head of Alhambra Investment Partners, said these derivative contracts are the most reliable, especially early-warning indications that exist. Like the bond yield curves, the Eurodollars strip warns that tighter monetary policy in the near term could choke economic growth, which will be necessary for an easing cycle.
Financial markets reckon the Fed will have to take a more aggressive stance next year, as annual inflation is edging toward 7%, the highest since 1982. The behavior of the rates futures and yield curves is reflected in this.
It's not likely that a recession is imminent. The US economy is expected to grow by more than 4% next year and the yield curve, notably the 2 s 10 s part of the curve, is still positively sloping.
It may be when the risks start to crystallize, especially if the yield curve inverts.