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What the Fed Is Missing, Again

22 Jul 2018 2:00 pm
By Justin Lahart 

The Federal Reserve isn't worried about the yield curve, and it has reason why. The problem: It is pretty much the same reason it wasn't worried about the yield curve before the financial crisis.

The yield curve -- the difference between shorter and longer term Treasury yields -- is important for the signals it sends about the future of the economy. The curve has gotten awfully flat lately, not a good sign for the future.

The 10-year Treasury yield, at 2.89%, is just 0.3 percentage point higher than the yield on the two-year Treasury. With the Fed on course to keep raising short-term rates, it is easy to imagine the two-year yield rising above the 10-year yield. That is a worrisome, since such yield curve inversions have been a reliable indicator of coming recession.

An inverted curve is a signal investors believe that the Fed's current rate-raising efforts are going beyond what the economy can handle and overnight rates will eventually fall. Fed policy makers don't seem to think that is the risk now.

Rather, they think longer-term yields are lower than they should be because of all the bonds purchased by the Fed and other central banks to prop up their economies. They believe that has driven term premia -- the extra yield investors demand for the risk of lending over a long period -- negative. Usually, term premia are positive.

Indeed, according to New York Federal Reserve estimates, if the average term premia that prevailed over the past 25 years were in effect today, the 10-year Treasury yield would be about 1.4 percentage points higher than the two-year yield.

In 2006, the Fed's view of the inverted yield curve was that a global saving glut had pushed down long-term interest rates. Meeting transcripts show policy makers believed this had driven down term premia, just as they see the glut of central bank holdings driving down term premia now. As a result, they weren't all that worried about the inverted yield curve. By the end of 2007 the economy had entered a recession and they were frantically cutting rates.

In the Fed's defense, it probably was right in 2006 about the cause of low long-term rights. What it missed was that those low rates drove investors to take on more risk -- in many cases risks they didn't understand -- to boost yields.

Today, evidence abounds -- from super tight spreads to negative yields to high stock valuations to the popularity of structured products -- that investors are willing to take on risks to capture yield. Since the financial crisis, the Fed has paid more attention to such dangers. But it appears to have a blind spot when it comes to the cause of the flattening yield curve. Ignoring the market's message seems reckless.

Write to Justin Lahart at justin.lahart@wsj.com
 

(END) Dow Jones Newswires

July 22, 2018 10:00 ET (14:00 GMT)

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