The Risk of Yield Curve Inversion—and How to Avoid It

The possibility of nominal yield curve inversion—which occurs when the nominal interest rates on shorter-term government debt are higher than those on longer-term government debt—has drawn more attention from policymakers and financial markets in recent months.For more on this topic, see my presentation on July 20, 2018, “Assessing the Risk of Yield Curve Inversion: An Update,” in Glasgow, Ky. I see this potential inversion as a key issue in U.S. monetary policy in the near term.

A Flattening Yield Curve

While the spread between longer-term Treasury yields and shorter-term Treasury yields currently remains positive, it has narrowed in recent years—leading to a so-called flattening yield curve. For instance, the spread between 10-year and one-year Treasury yields was close to 300 basis points (or 3 percentage points) at the beginning of 2014 but declined to less than 40 basis points (or 0.4 percentage points) in late August 2018. Subsequently, the spread has increased slightly.For a FRED graph showing this spread from 2012 to the present, go to https://fred.stlouisfed.org/graph/?g=lqqB.

What has driven the flattening of the yield curve? The Federal Open Market Committee (FOMC) has been raising the policy rate (i.e., the federal funds target rate) since December 2015, and thus shorter-term interest rates have been rising. At the same time, however, longer-term interest rates have not risen as rapidly as shorter-term rates.

Risk of Yield Curve Inversion

In my view, there is a material risk that the yield curve will invert if the FOMC continues on its current projected path for the policy rate. Let’s suppose that longer-term yields remain near current levels and that the FOMC remains on track to raise the policy rate at the pace suggested in the FOMC’s September 2018 Summary of Economic Projections (SEP). Under this scenario, and based on projections for one-year Treasury yields,I calculated projections for the one-year Treasury yields as the SEP median fed funds rate plus the current spread between the one-year Treasury rate and the fed funds rate. the U.S. nominal yield curve would invert in late 2018 or early 2019.

Historically, an inversion of the yield curve has been a bearish signal for the U.S. economy and has helped predict recessions. Furthermore, such an inversion would suggest that the Fed and the financial markets have different outlooks for the U.S. economy. This is because the 10-year Treasury yield is a bellwether rate determined mostly by market forces, and the one-year yield is closely related to the Fed’s policy rate.

Avoiding an Inversion

Yield curve inversion could be avoided in two ways—if longer-term nominal interest rates begin to rise in tandem with the policy rate or if the FOMC does not raise the policy rate as aggressively as suggested by the SEP.

Longer-term nominal interest rates (without inflation adjustment) could begin rising more rapidly if longer-term real interest rates (with inflation adjustment) begin to rise, which may happen if investors perceive greater growth prospects for the U.S. economy going forward—say, over a 10-year horizon. I see little prospect of this at the moment though, as the 10-year real interest rate has been roughly constant since 2014. Another way that longer-term nominal yields could begin increasing is if longer-term expected inflation begins to rise, which may occur if investors perceive greater risk of higher inflation in the U.S. economy going forward. But this doesn’t seem to be happening either, as longer-term inflation expectations remain relatively low. Consequently, it seems unlikely that longer-term nominal interest rates will begin to rise in tandem with the Fed’s policy rate.

The best way to avoid yield curve inversion in the near term is for policymakers to be cautious in raising the policy rate. Since U.S. inflation expectations are currently tame, it is unnecessary to push monetary policy adjustment to such an extent that the yield curve inverts. The FOMC could move to a slower pace of rate increases than what is currently projected—or no planned rate increases—and see how the data evolve. If longer-term yields start to rise or inflation pressure starts to build, then the FOMC could continue with rate increases.

According to recent data, the U.S. economy is doing well and the yield curve continues to have an upward slope. So, why debate this issue now? In addition to looking at the current macroeconomic situation, it is important to look at how it is likely to evolve over the next two or three years.

Some argue that this time is different when it comes to the yield curve.For example, see Johansson, Peter; and Meldrum, Andrew. “Predicting Recession Probabilities Using the Slope of the Yield Curve,” FEDS Notes, March 1, 2018; and Engstrom, Eric; and Sharpe, Steven. “(Don’t Fear) The Yield Curve,” FEDS Notes, June 28, 2018. These models, which include additional or alternative variables to the typical yield spread, indicate increased recession probabilities before past recessions but a relatively low probability currently. I recall similar comments relative to the yield curve inversions in the early 2000s and the mid-2000s—both of which were followed by recessions. To be sure, yield curve inversion could be driven by factors that are unrelated to future macroeconomic performance. Nevertheless, the empirical evidence that an inverted yield curve is a good predictor of recessions is relatively strong. The FOMC does not have to be aggressive with policy rate hikes until warranted by inflation or other economic data.