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Will the Fed Go Too Far in This Cycle? 3 Indicators to Watch

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October 04, 2018

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1 year 8 months
Submitted by satya.billa on Thu, 10/04/2018 - 13:00

If the Federal Reserve raises interest rates too much or too fast, it could tip the economy into recession.

Signs that the Fed may be going too far too fast include a flat or inverted yield curve, a decline in inflation expectations, and tightening credit.

At this point, we see only one indicator—the flattening yield curve—that could be signaling an eventual end to the rate-tightening cycle.

There’s an old saying that when the Federal Reserve tightens policy, something breaks. That’s because rising interest rates expose borrowers who have taken on more debt than they can handle. In past tightening cycles, the Fed has sometimes gone too far, raising rates too much or too quickly, and ended up hastening an economic recession—however, the central bank’s overreach was apparent only in hindsight. 

The Fed began raising its benchmark short-term interest rate in December 2015. Since the current tightening cycle began, the Fed has hiked seven times, bringing the federal funds rate target range to 2% to 2.25% as of September. The Fed’s “dot plot,” a projection that shows where each participant in the policymaking meeting thinks the federal funds rate should be at various points in the future, suggested in September that another hike is on the table this year and three more hikes are likely in 2019.

While it’s nearly impossible to tell in advance whether the Fed will go too far—that’s a question Fed policymakers themselves struggle with—there are a few things that historically have occurred as the Fed has reached the functional end of a tightening cycle. Keeping an eye on these market indicators may help investors gauge whether the Fed is near the end of the cycle or likely to overshoot, and whether it’s time to make portfolio changes to manage potential risk.

1. The yield curve flattens

Over time, as the Fed raises short-term rates, borrowing becomes more expensive and investors begin to expect slower economic growth in the future. That usually causes longer-term yields to decline. At some point, short- and long-term yields converge, and the yield curve¹—which normally curves upward—becomes flat, or even inverted (meaning short-term rates are higher than long-term rates). This convergence between short- and long-term rates historically has marked a peak in bond yields and a low point for bond prices (which move inversely to yields).

In past cycles, 10-year bond yields and the federal funds rate have peaked around the same level

Source:  Effective Federal Funds Rate, (FEDFUNDS) and 10-Year Treasury Constant Maturity Rate, Percent, Monthly, Not Seasonally Adjusted (DGS10). Data as of 10/1/2018. Shaded areas represent past recessions. Past performance is no guarantee of future results.                                                                                              

So far in this cycle, the yield curve has already flattened significantly. The difference between the yield on a three-month Treasury bill and a 10-year Treasury bond has narrowed by about 115 basis points², from roughly 200 basis points in December 2015 to only 86 basis points at the end of September. Meanwhile, inflation expectations have been fairly steady, in the 2% to 2.5% region.

The yield difference between 3-month Treasury bills and 10-year Treasury bonds has narrowed

Source:  Bloomberg. 10-Year Treasury Constant Maturity Minus 3-Month Treasury Constant Maturity, Percent, Daily, Not Seasonally Adjusted. Monthly data as of 9/27/2018.

This means that, barring a sudden jump in economic growth or inflation expectations, it would only take two to three more 25-basis-point rate hikes by the Fed to cause short and long-term rates to converge.

2. Inflation expectations decline

As the Fed tightens monetary policy, making borrowing more expensive and slowing economic growth, investors’ expectations for future inflation usually soften. This can also be a sign that bond yields have peaked.

How can you tell whether inflation expectations have eased? One common method is to compare the yield of a Treasury Inflation-Protected Security (TIPS) with the yield of a comparable-maturity traditional (that is, non-inflation-protected) Treasury security. TIPS generally offer lower yields than Treasuries, because their coupon payments rise as inflation rises, while the principal value of a traditional Treasury is fixed. The difference between the two yields is called the breakeven rate, and is a key measure of what investors expect in terms of future inflation.

For example, if a 10-year Treasury offers a yield of 3% and a 10-year TIPS offers a yield of 1%, then the breakeven inflation rate is 2%. That is the average rate of inflation that investors expect to see during the next 10 years.

The 10-year inflation breakeven rate is currently 2.13%

Source: Bloomberg, 10-year U.S. Breakeven Inflation Rate (USGGBE10 Index). Daily data as of 10/2/2018.       

As you can see, the 10-year breakeven rate has trended sideways this year, and is currently just below its 2018 high of 2.18%. The most recent reading for the Consumer Price Index, in September, was 2.7%. 

If inflation expectations begin to decline, it could be another signal that bond yields have peaked and the Fed should be near the end of its tightening cycle.             

3. Credit conditions tighten                                            

Another late-cycle phenomenon is tightening credit conditions—that is, loans become harder to get and more expensive. To date, there are few signs of tightening credit conditions. The yield spread between corporate bonds and Treasuries is relatively narrow, for both investment grade and sub-investment-grade borrowers, indicating that banks and investors aren’t very concerned about the risk of default. Also, the terms and conditions for sub-investment-grade borrowers are still easy. The Federal Reserve Bank of Chicago’s National Financial Conditions Index shows little sign of tightening credit conditions.

The Chicago Fed National Financial Conditions Index shows little sign of tightening credit conditions

Source: Federal Reserve Bank of Chicago.  Chicago Fed National Financial Conditions Index, Index, Monthly, Not Seasonally Adjusted. Shaded areas represent past recessions. Positive values of the NFCI indicate financial conditions that are tighter than average, while negative values indicate looser-than-average financial conditions. Monthly data as of October 2018. 

What happens if these signals occur?

In general, once yields have peaked, historically two things have happened:

  • Longer-term bond yields have fallen, and longer-duration bonds have tended to outperform shorter-duration bonds;
  • High yield or riskier segments of the market have tended to underperform relative to higher-credit quality-bonds.

However, it’s important to note that if you wait for all of these signals to flash, there’s a good chance bond yields already will have begun to decline and riskier segments of the market may have begun to weaken. While keeping an eye out for a change in the market landscape, we also suggest considering the following actions:

  • Maintain short-to-intermediate term duration. With only one of the above indicators—the flattening yield curve—signaling a potential end to the rise in bond yields, we continue to suggest that investors maintain short to intermediate average duration (in general, that’s two to five years for corporate and Treasury bonds) in their fixed income portfolios, and consider floating rate notes as a way to increase income as short-term interest rates rise.
  • Put short-term performance in perspective. Despite the lackluster performance of the fixed income markets so far this year, overall returns for investors have been positive in every asset class since the Fed began raising interest rates in December 2015, as reflected in the chart below.

Since the Fed began raising rates in 2015, total returns for major fixed income indexes have been positive   

Source: Bloomberg Barclays. Total return data for 12/14/2015 to 9/28/2018. Indexes are unmanaged, do not incur management fees and cannot be invested in directly. Cumulative returns assume reinvestment of income. Past performance is no guarantee of future results.

  • Stay invested. It’s tempting to try to time the interest rate cycle, but it’s not easy. There are ways to mitigate the risks we see on the horizon, but trying to catch the peak or trough in yields is very difficult. Staying invested and focusing on matching the duration of your bond investments to your investing time horizon and tolerance for risk still makes sense for most investors, whether interest rates are rising or falling.

 

¹ A yield curve is a line that plots the interest rates, at a set point in time, of bonds having equal credit quality but differing maturity dates.

² A basis point is one hundredth of one percent, or 0.01%.

  • Make sure your portfolio is diversified and aligned with your risk tolerance and investment timeframe. Want to talk about your portfolio? Call a Schwab Fixed Income Specialist at 877-566-7982, visit a branch or find a consultant.
  • Explore Schwab’s views on additional fixed income topics in Bond Insights.
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