Last Friday, the US Federal Reserve cleared the final hurdle on the path to an interest rate hike. The first, as many analysts predict, of three or four increases this year depending upon the inflation rate growth.
That hurdle was the jobs report, which exceeded expectations by registering an additional 235,000 employed citizens, accompanied by a welcome growth in wages; a factor that has lagged behind throughout the economic recovery.
In line with comments made by Fed Chair Janet Yellen, who signalled that a March hike is “likely appropriate” if “employment and inflation are continuing to evolve in line with our expectations” and New York Fed President William Dudley who stated that the case for an interest rate increase is “a lot more compelling”, the probability of such an action at the next Federal Open Market Committee meeting on the 14-15th March has been priced in at 100%.
One concerning trend, last witnessed between the years of 2004-2006 preluding the global financial crisis, is that despite the sensitivity of short-term Treasury bond yields to adjustments in monetary policy, the yields on longer duration Treasury bonds have remained relatively static.
This has created a flattening of the yield curve due to the reduction of spread between the 2-year and 10-year bond yields, known as the ‘Greenspan Conundrum’ after Alan Greenspan who first alluded to the problem during his tenure as Fed Chair.
What Is the Greenspan Conundrum?
Raising short end rates does not shift long-term yields. As a result, the yield curve becomes flat and in some cases, inverted. This is important as an increase of spreads usually indicates that investors are optimistic about the growth rate of the economy while, on the other hand, a narrowing of spreads implies a weakening economic outlook.
There are numerous reasons for this phenomenon. Domestically, when the Federal Reserve increases interest rates borrowing costs grow higher for consumers and businesses. With variable rate loans dependent upon the benchmarks that are tied in with this rate, an increase in interest rates escalates the cost of servicing debt, hence decreasing consumer spending. In turn, this reduces economic growth and inflation, indicators which guide the movement of the long duration yield. As such, a policy of increasing rates resulting in lesser growth and inflation has lowered the 10-year yield.
The BOJ Example
In 2001, the Bank of Japan launched a quantitative easing programme designed to stimulate growth following the Asian financial crisis. This resulted in a suppression of bond yields, and unbeknown to the market at the time, also had an adverse effect on long term US treasuries. In addition, the major Asian economies sought to boost foreign reserves in order to defend against capital outflows in the event of a future crisis. These countries grew reserves by issuing debt to their citizens to mobilise domestic saving, before using the income to buy US Treasury bonds. Very simply, inflows into long-term rates drove down yields independent of changes in US monetary policy.
Both of the aforementioned domestic and international factors set the scene for these abnormal conditions, which emerged when then-Fed Chair Alan Greenspan began a series of interest rate hikes in order to tame the booming real estate sector, in 2004. Short-term yields increased while long-term yields fell, hence a conundrum that dumbfounded the brightest minds in the industry.
This trend is problematic as it highlights the Fed’s inability to control longer-term rates, which are usually set by global market participants. It may also indicate that the timing of a rate hike is inappropriate, which historically only occur with both growth and inflation above trend.
Both of these factors usually increase the long-term yield, which allows short-term yields to increase without flattening the spread curve. If an interest rate increase causes the spread to decrease, then this may indicate that there are insufficient growth and inflation to justify the hike.
A flattening of the curve can, in effect, mean the onset of economic decline:
As the above chart shows, a reduction in the yield spread curve has in the past resulted in a period of potent economic downturn. Starting firstly with the early 1980s US recession, through to the financial crisis beginning in 2007.
Worryingly, whenever the above graph reached the sub-zero percent relationship, the economy has fallen into recession. The current trajectory of this curve is to once again decline to 0% within the next couple of years, which may foreshadow a new period of economic misery.
While the Federal Reserve committee remains on course for a further two or three interest rate hikes this year, a lot of attention will be paid to the re-emergence of this conundrum. The next financial crisis or even simply a stock market correction is a case of when, not if, and the above graph could be key to predicting this imminent danger.