Introduction:
Many analysts quoted in the popular press believe that interest rates have peaked, inflation is receding, the fed has tightened too far, and a recession is likely.
- A July 7, 2022, a CNBC article suggested there was a high likelihood of a recession because of the inverted yield curve (The 2-year T-bill rate was 4.9 percent and the 10-year rate was 3.9 percent at the time.)
- An October 6, 2023, Reuters article stated that a bear steepening of the U.S yield curve dashes ‘soft landing’ hopes. (The 2-year interest rate is 5.1 and the 10-year rate is 4.7 at the time of the Reuters article.)
- Analysts, in this CNBC article anticipate Fed cutting interest rates and inflation receding in 2024.
The analysis presented here confirms that considerable increases in interest rates off their lows has occurred. However, interest rates are by no means high compared to to historic figures. Moreover, the 10-year Treasury bond rate remains low relative to other interest rates and will continue to rise under the most realistic economic scenarios.
Some observations about interest rates:
Until recently, interest rates have been abnormally low and additional tightening while not immediately necessary could occur.
- The median Fed Funds rate between 2011 and 2023 of 0.16 percent was far lower than the median Fed Funds rate of 5.50 between 1976 and 2010.
- The current Fed Funds rate of 5.33 is close to the median Fed funds rate from the 1976 to 2010 period.
- The Fed could go further if inflation accelerates. The Fed funds rate went as high as 19 percent in 1981.
While Fed policy impacts interest rates, market forces also matter. There is substantial disparity in recent movements of different rates. In particular, the 10-year Treasury rate appears abnormally low compared to the Federal Funds rates and rates determined by the market.
- The current two-year Treasury rate slightly above 5.0 percent is pretty close to the average two-year interest rate over the 1976 to 2023 period.
- The current 30-year fixed rate mortgage of 7.89 percent is 21 basis points higher than the average over the 1976 to 2023 period.
- The current 10-year Treasury interest rate of 4.71 percent is 118 basis points below the average over the 1976 to 2023 period.
- This picture of the differential between the 10-year and 2-year constant maturity interest rate created by the Saint Louis Federal Reserve Bank reveals the differential is usually positive but has been mostly negative over the last 1 ½ years.
- The current differential between the 30-year fixed rate mortgage and the 10-year Treasury bond is 318 basis points. By contrast, the average differential between 1976 and 2023 is 179 basis points.
Discussion: The recent bear curve steepening is not over. I expect the 10-year Treasury bond rate will continue to rise until it is in line with Fed policy and rates on other assets in the market.
My most likely economic scenario assumes the Fed will pause but not cut rates and that inflation will remain near its current levels. The following recommendations are based on this outlook.
- Continue to eschew the purchase of long-term bonds and bond funds without a fixed maturity date.
- Focus most fixed-income assets in a bond/CD ladder with a maximum maturity of two years.
- Allocate a small portion of the fixed-income portion of the portfolio to agency debt with a maturity of five years.
- Continue purchasing Series I Savings bonds.
This strategy is premised on the view that inflation remains stable near current rates and the
Fed pauses rate increases. This scenario is more likely than additional Fed tightening, a soft landing and a hard landing into an immediate recession.
My next macroeconomic post will be on the likely of higher wage-push inflation and its impact on the economic outlook.
Authors Note: The author, an economist, is planning to publish and market a quarterly economic outlook. He is available for economic and financial consulting projects. His recent paper on the impact of student debt and additional education on household finances can be found here. Also, please considering the kindle paper, A 2024 Health Care Reform Proposal.