Yellen’s yield curve musings a worrying echo of Greenspan & Bernanke

U.S. outgoing Federal Reserve Chair Janet Yellen holds a news conference after a two-day Federal Open Market Committee (FOMC) meeting in Washington, U.S. December 13, 2017. REUTERS/Jonathan Erns

LONDON (Reuters) – Janet Yellen used her last press conference as Fed Chair to muse that a flat yield curve should not be interpreted as a sign that the economy is heading for a slowdown.

In other words, “This time it’s different”.

Seasoned Fed-watchers will be forgiven for feeling a sense of deja vu: Her predecessors Alan Greenspan and Ben Bernanke spun exactly the same line before the last U.S. recession began.

In July 2005, then Fed chairman Alan Greenspan told the Senate Banking Committee there was a “misconception” of the importance of the yield curve. “The curve’s efficacy as a forecasting tool has diminished very dramatically,” he said.

The supposedly unusual behaviour of long-term yields, where they fell even though interest rates were rising – a phenomenon Greenspan dubbed a “conundrum” – first became apparent in 2004.

The Fed started a tightening cycle in May that year with the fed funds rate at a half-century low of 1 percent which would end two years later with borrowing costs at 5.25 percent.

In March 2006, barely a month after succeeding “the Maestro” as Fed chair, Ben Bernanke echoed Greenspan’s skepticism that the yield curve was a harbinger of darker economic times ahead.

“I would not interpret the currently very flat yield curve as indicating a significant economic slowdown to come, for several reasons,” he told the Economic Club of New York on March 20.

Bernanke presided over the last stage of a two-year tightening cycle that saw Fed interest rates rise 425 basis points while the 10-year Treasury yield climbed only 40 bps.

The gap between two- and 10-year yields shrank to zero at the end of 2005 from 225 bps at the start of the cycle, and the curve inverted in early 2006.

The curve remained inverted well into 2007, just before the economy tipped into recession in December that year.

In short, two Fed chairmen within eight months of each other were heard downplaying the significance of depressed long-term rates and arguing that the underlying economy was much stronger than the flattening curve suggested.

To be fair to Greenspan and Bernanke, recession didn’t strike until long after they questioned the yield curve’s predictive powers. That was partly due to the slow, gradual and well-telegraphed nature of the Fed’s 2004-06 tightening cycle.

With inflation so muted at the moment, the Fed’s current tightening cycle is even shallower. The first hike was two years ago, and the ultimate policy rate will almost certainly be well below the pre-crisis average.

So if recession arrives the same length of time after Yellen’s yield curve remarks as it did after Greenspan’s or Bernanke‘s, the good times for investors may roll for another couple of years yet.

In response to the last question at her final press conference last week, after nearly four years at the helm of the U.S. central bank, Yellen effectively dismissed the current flatness of the yield curve as little more than a technical anomaly.

“I think there are good reasons to think that the relationship between the slope of the yield curve and the business cycle may have changed,” Yellen said.

She noted that “term premium” – the yield premium demanded for the lack of forecasting visibility over the lifetime of a longer-dated bond – is virtually nil. Investors are pricing in very little inflation, credit, or any other risk.

Certainly, the U.S. economy appears to be humming along quite nicely. Growth is running at over 3 percent a year, unemployment is the lowest in 17 years, and stock markets are breaking new records nearly every day.

An indicator of activity across the country’s housing market released on Monday showed the highest reading since 1999.

So maybe the yield curve has indeed lost its economic predictive qualities, and maybe it really is different this time.

Or not. The economic expansion is already the second-longest on record and is closing in on the longest ever. The thing about recessions and even slowdowns is they often hit when the outward signs are still rosy.

If the Fed tightens policy next year as much as it has indicated, the curve will probably invert, making it unprofitable for banks to lend. The drying up of credit will slow economic activity and bring recession onto the horizon.

That’s the theory, and some Fed officials are now expressing concern at the shape of the yield curve. St. Louis Fed President James Bullard said this month that curve inversion “is a naturally bearish signal… This deserves market and policymaker attention.”

Exactly how much attention will become apparent in the weeks and months ahead.

The opinions expressed here are those of the author, a columnist for Reuters. 

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