The ol' yield curve just ain't what it used to be
The ol' yield curve just ain't what it used to be: the yield curve has been a decent harbinger of recession, with the most recent experience seen in late 2006-early 2007 when the curve inverted ahead of the financial crisis. And recent FOMC minutes have shown increased discussion over the yield curve and what the flattening might signal about economic activity, and more specifically the potential for recession. A number of factors were cited as contributing to the narrowing, outside of the tightening posture. Those included reduced investor forecast of the longer-run neutral real rate, lower long-term inflation expectations, a lower level of term premiums relative to history, which in part is related to QE, as well as asset purchases by other central banks. As seen in various Fedspeak, and noted in the minutes, policymakers have differing opinions on whether such factors are compromising the reliability of the yield curve as a recession indicator, while others doubted potential distortions. Analysts note that much of the narrowing has been a function of the failure of longer dated yields to rise and believe that Fed QE, and that of other core central banks, have sufficiently distorted the curve to diminish its signaling ability. Low underlying inflation trends have also impacted. Meanwhile, Fed hawks appeal to the Philips Curve and the potential for rising prices as the labor market tightens, but analysts see more slack in the job market, as indicated by the June employment report, to keep wage pressures modest. In terms short dated yields, analysts find they've been significantly impacted more by risk-on/risk-off flows, as well as supply volatility, than merely Fed policy, as the FOMC maintains a gradual, largely well telegraphed, policy path. Analysts don't believe the curve is yet signaling a recession, though it's still a work in progress. And the FOMC has nothing definitive either, so its conclusion was to continue monitoring the spread, and that's what analysts'll do too.