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Chart In Focus

Yield Curve’s 15-Month Lag

Chart In Focus
June 20, 2024

Economists got very animated in late 2022 when the Fed's hiking of short term interest rates resulted in an inversion of the yield curve.  Inversion happens when short term rates go above long term rates, which is not typically the condition rates are supposed to be showing.  Most of the time, long term rates pay higher yields than short term ones, and that makes sense.  If you are going to lock up your capital for a longer time, you would expect to get paid more for that. 

Yield curve inversions have a perfect track record of always bringing economic recessions.  And yet a lot of economists are thinking that it is different this time, and that the Fed has somehow managed to engineer either a "soft landing" for the economy, or a "no landing" scenario in which GDP never shrinks and the good times just keep rolling.

This complacency comes about via a poor general understanding about how and when yield curve inversions work.  The effect of an inversion is not felt right away, but rather with a lag time of about 15 months. 

This week's chart shows the spread between the 10-year and 3-month Treasury yields.  It is shifted forward by 15 months to help illustrate how GDP responds with that lag time.  This yield spread first inverted on a monthly basis back in November 2022.  Counting forward by 15 months takes us to February 2024, which was in the first quarter (Q1).  We did not get a negative real GDP growth rate in Q1, but it did fall to a very low positive number.  The full effect of the current inversion of the 10y and 3m rates has not yet been felt.

Furthermore, that economic effect should continue to be felt for a period of 15 more months after the 10y-3m spread finally disinverts.  In other words, the FOMC members might believe that they are fighting current inflation right now by making current economic conditions tougher via their high interest rates.  But in reality, the effect is delayed, and so the continuing inversion of the yield curve means poor GDP conditions for 15 more months after the moment when the yield curve disinverts.  And we do not see any sign yet of any disinversion happening anytime soon. 

If I could impose one change on our economic system, I would have the Fed outsource setting short term interest rates to the bond market.  Let the 2-year T-Note yield determine the Fed Funds target rate.

2-year t-notes and fed funds target rate

This chart shows that the 2-year yield knows ahead of the Fed what the Fed is going to do.  We all get into problems when the FOMC members with their expensive economics degrees think that they know better than the bond market.  When they keep rates too low, meaning lower than what the 2-year yield says, then they help to fuel bubbles in both the stock market and the economy.  And when they keep the Fed Funds target rate too high, like they are doing now, they overdo the braking force, leading to big problems. 

But as far as I know, none of the FOMC members reads this Chart In Focus series, and they probably would not accept that suggestion from me anyway.  People generally do not like to be told that someone (or something) else could do a better job they they do.  So we will just have to live with having a Fed which is almost always behind the power curve, and which is going to keep stepping on the gas or the brakes at the wrong time.

Tom McClellan
Editor, The McClellan Market Report

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