Running Out of Options? | August 3, 2018

The economic cycle has been running for 112 months, well beyond its 68-month average.  Are central banks running out of options to sustain it going forward?

For years, the question was “When will the Federal Reserve Bank (FRB) raise rates?” Now it is, “When will they stop?” As they raise the short end of the yield curve, the long end has been unresponsive.  Concerns are mounting that FRB activity could actually cause a recession.  Every recession, over the last 50 years, has been preceded by an inverted yield curve (where short dated bonds earn more interest than long dated bonds).

The FRB has no intention of causing a recession–that would cause unemployment to spike–one of their key mandates.  Also, they have been unable to adequately rebuild the arsenal in preparation of the next recession.  So, if the FRB is left with little option regarding raising short term rates, how can they influence longer rates higher?  Their balance sheet is an excellent source of longer dated bonds. Selling their balance sheet would have a steep supply of long dated bonds hit the market, which would increase rates.  Doing so would steepen the yield curve and give them room to continue rate hikes on the short end; both actions would help rebuild their arsenal. This process would have the unfortunate effect of a rout in bond markets in the short term (as prices move in the opposite direction of rates).

They may not have to take such drastic measures, however. The long end of the curve has remained so low, in part, due to other developed country interest rates at all-time lows. This is caused by their central banks being more accommodative than the US; a trend that is beginning to shift. Outside of geo-political risk, rates across Europe, Japan, including the UK have begun to increase, supporting the future upward trajectory for the US 10-Year Treasury.

 

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