Fed Restrictive Monetary Policy
Last Monday, Federal Reserve Chairman Jerome Powell vowed tough action on inflation, which he said jeopardizes an otherwise strong economic recovery. "The labor market is very strong, and inflation is much too high," the central bank leader said in prepared remarks for the National Association for Business Economics. The speech comes a week after the Fed raised interest rates for the first time in more than three years in an attempt to battle inflation that is running at its highest levels in 40 years. In its post-meeting statement, Powell said interest rate hikes would continue until inflation is under control, reiterating the Federal Open Market Committee's position. FOMC officials indicated that 25 basis point increases are likely at each of their remaining six meetings this year. However, markets are pricing in about a 50-50 chance that the next hike, at the May meeting, could be 50 basis points.
As of today, 10-year Treasury rates are up more than 60 basis points (0.60%) so far in March, rising more than 30 basis points last week, bringing the 10-year yield to its highest level since May 2019. There hasn't been an increase as fast as this since September 2019. In addition, over the last decade, there have been only four other weekly increases of 30+ basis points. With inflation running at 40-year highs and the Fed commencing a tightening campaign the previous week to rein consumer price increases, rising bond yields are responding to a new monetary policy regime.
Stocks slipped to their lows of the session after Powell's remarks, while Treasury yields rose.
‘Widely underestimated’ inflation
The sudden policy tightening comes with inflation, as measured by the consumer price index, running at 7.9% on a 12-month basis; prices are up 5.2%, well above the central bank's 2% target.
As he has before, Powell addressed much of the pressures to Covid pandemic-specific factors such as Supply chain constraints. Fed officials and many economists underestimated how long those pressures would last. While those aggravating factors have persisted, the Fed and Congress have provided more than $10 trillion in fiscal and monetary stimulus since the pandemic. The Fed Chairman believes that inflation will drift back to the Fed's target; a change in policies is needed, though. Powell also addressed the Russian invasion of Ukraine, saying it is adding to supply chain and inflation pressures. Under normal circumstances, the Fed generally would look through those events and not alter policy. However, policymakers have to be wary of the situation, with the outcome unclear.
Furthermore, the FOMC will run off about $9 trillion in assets on its balance sheet, beginning as soon as May.
Perhaps the most noticeable economic impact of rising rates is the jump in mortgage rates which are now up a full percent since the beginning of the year.
Bond yields are increasing, with the Fed outlooks estimating a more than expected increase in rates.
According to Mortgage News Daily, the average rate on the 30-year fixed mortgage hit 4.72% on Tuesday, increasing by 26 basis points in less than a week.
As a result of the recent spike in rates, economists are now lowering their yearly home sales forecasts. At the end of last year, most estimates had the average 30-year mortgage rate hitting 4.5% by 2022, but the war in Ukraine, rising oil prices, and inflation firmly pushed up interest rates. Last year, rates were about 3.45% in this same period.
Economists previously expected a slight increase during 2022, but current events are changing this perspective. Lawrence Yun, the chief economist for the National Association of Realtors, now says he expects the rate to hover around 4.5% this year after predicting it would stay at 4%. NAR's latest official prediction is for sales to drop 3% in 2022. Yun, however, believes that they will decrease by 6%-8% (NAR has not officially updated its forecast).
The rise in rates affects an already crazy housing market. Demand remains strong, and supply remains historically low. Home prices have already increased by 19% in January (year over year).
Yield curve: is a recession coming?
An inversion of the U.S. Treasury yield curve has been regarded as a precursor to a recession for decades; it has never failed since the 1950s, and it appears now to be turning down again. There have been seven major U.S. recessions since 1960, and they were all predicted by it.
The U.S. Treasury yield is constantly fluctuating in the open market. Theoretically speaking, the longer a bond takes to be repaid, the higher the interest rate will be, at least in normal and stable times. When the economy is in a slump, however, the yield curve inverts its shape, paying higher interest rates on short-term maturities and lower interest rates on longer maturities. As a matter of fact, if the economy is widely expected to struggle soon, investors request high-interest payments on short-term bonds, being less likely to be paid back in such turbulent times.
Short-term interest rates reflect the Fed's restrictive monetary policy (on the other hand, 10y bonds rates represent a long-term forecast of the economy), which is being used to fight inflation. These kinds of strategies could eventually squeeze credit, though, causing a recession. So, if inflation doesn't recede as planned and the central bank pushes forward with rate hikes further into 2023 or beyond, then a recession could become more of a threat than it is now.
However, this possible recession shouldn't be totally viewed as such a bad thing; at times, a yield curve inversion and a recession are the necessary prices to pay to reduce a high inflation rate, as occurred in the early 1980s when then-Fed Chairman Paul Volcker used high-interest rates to lower and control double-digit inflation.
The much-observed difference between the two yields (2y vs. 10y interest rates) reversed last week. On Friday, April 1st, the yield on two-year Treasury bonds reached 2.44%, and the yield on 10-year bonds reached 2.38%. Of course, an inversion of the curve doesn't surely mean that a recession must happen, but it might.
There are many debates on how to forecast the future of the global markets and economy; in particular, not everyone agrees that the correct way to do so is by comparing 2y and 10y bonds' interest rates. For instance, many researchers advocate that would be more precise in comparing three and 18-months interest rates (instead of two- and ten-year rates). With this approach, there wouldn't be any "recession alarm"; as a matter of fact, short-term rates are much lower than expected rates at 18 months. In addition, this is the time frame that Federal Reserve's Chairman Jerome Powell prefers. But there is no general or certain agreement on which spread serves as the most reliable recession indicator.
Another explanation is that the Federal Reserve has been one of the single largest buyers of long-term U.S. Treasuries in the last decade. They have been doing so to boost the economy's growth after the 2007's financial crisis. This is not a terrible thing, but it can result in the distortion of the U.S. bond market, contributing to the realization of an inverted yield curve and giving people false signals about the future of the U.S. economy.
In the end, it must be said that the predictive powers of inversion have never really been tested at a time when central banks are holding massive amounts of long-term debt, so there is no ultimate answer. An inverted yield curve certainly doesn't mean a recession has to happen, but it has happened before every recession. Yet it is important to note that it is not infallible. Indeed, part of what makes the inverted yield curve so mesmerizing is the mystery behind it.