In recent months, we have witnessed a strong repricing of the US yield curve. The move is a result of persistently high inflation, a buoyant labor market and consecutive signals from the Fed suggesting that monetary policy tightening will be faster than expected.
As in the most recent episodes of interest rate hikes, there is still fear of its consequences. For the first time since August 2019, the “inversion” of the yield curve, with long-term yields below short-term ones, has ignited discussion about the possibility of the Fed causing a recession.
Yield curve inversions typically signal pessimism about the economy’s growth prospects and have preceded nearly every US recession in the past 50 years. When investors fear an economic slowdown, they also tend to expect the Fed to lower the benchmark rate in the future, causing the reversal movement.
Typically, the recession occurs two years after the reversal between the two- and ten-year timeframes. Last week, two-year rates rose to 2.45% (the highest level since March 2019), while ten-year rates dropped to 2.38%. The difference between five-year and 30-year earnings — another closely monitored measure — was reversed for the first time since 2006.
The expectation that high short-term interest rates pose a risk to the economic scenario ahead is justified. The Fed’s starting point is challenging: inflation is well above its 2% target, with a CPI (consumer index) at 7.9%, while unemployment is at 3.6% – the lowest level in recent years. Inflation is not only high but widespread. Low unemployment has led wages to rise by close to 6% in the last 12 months, raising the chance that we are facing a price and wage spiral in the US. Everything indicates that the Fed’s extreme “patience” in this cycle could force it to slam on the brakes.
In a recent article in the NBER, Summers and Domash (“How Tight Are US Labor Markets?”) compare alternative labor market indicators with predictors of wage inflation and conclude that the current degree of tightening can be compared to times when the rate of Unemployment was below 2%.
It is not by chance that, in the minutes of the most recent Fed meeting, released this Wednesday (6), the committee expressed “strong commitment and determination to take the necessary measures to restore price stability”, announcing that the beginning of the reduction of its balance sheet will be twice as intense as in 2017. According to its members, the time is right to quickly exit the accommodative monetary policy stance and, depending on economic developments, a more restrictive stance may be justified. .
Fed Chair Jerome Powell has been trying to get the message across that a soft landing for the economy is more likely. In his most recent lecture, he cited three historical examples — the tightening cycles of 1964, 1984 and 1993 — as evidence that the institution can slow growth and reduce inflation without precipitating a recession. However, in none of these episodes was the job market in a situation similar to the one it is now. In 1964, the unemployment rate was at 5.1%, in 1984, at 7.8%, and at the beginning of the 1993 cycle, at 6.5%.
In a similar vein, in a study (“Don’t Fear The Yield Curve, Reprise”) recently published by the Fed, Engstrom and Sharpe present statistics that the 2-10 year curve inversion is likely to be spurious.
In fact, longer spreads are impacted by other factors, such as the risk premiums on long-term bonds. The longer curve inversion may not be such a reliable indicator of recession this time around, given the Fed’s massive bond purchases during the pandemic, which skewed the yield curve.
Whether a recession can be avoided, we don’t know; but, depending on the slowdown in US economic activity generated by the interest rate tightening, we could have relevant consequences on investors’ risk appetite and on global growth.
If, so far, emerging countries have benefited from international liquidity, high commodity prices and the fact that they are ahead of their cycles of monetary tightening, this scenario will change if it becomes clear that US interest rates will be substantially higher.
​In the case of Brazil, the appreciation of the exchange rate, which is capable of favoring the fall of our inflation and the Selic, would be reversed in an environment of greater global aversion to risk.
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