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January 17, 2018

Fed Raises Interest Rates Again; Caution Advised

In the second week of December 2017, Federal Reserve officials decided to raise interest rates. The Fed funds rate was raised from 1.25 percent to 1.50 percent, and along with this change, officials raised guidance on GDP growth to 2.5 percent, up from 2.1 percent forecasted in the September Fed meeting.

Along with this revised guidance, the Fed also indicated there would be three additional rate hikes in 2018, and two more in 2019. This would take the Fed rate up to 2.25 percent by the end of 2018 and to a guided 2.8 percent by the end of 2019. To put this in perspective, a 30-year treasury bond, as of mid-December 2017, yields 2.70 percent. The recent rises in interest rates, along with the Fed guidance for the coming years have many concerned about the yield curve flattening. The yield curve is the yield of fixed-interest securities plotted against the length of time. A healthy curve represents an increasing yield as the length of time is extended out. When a yield curve flattens, one can achieve the same yield buying a shorter term security as a longer term security, thus speeding up the credit cycle and rendering the longer term securities less significant.

Historically, after the yield curve inverts, a recession is not too far behind. Take a look at the following chart from Business Insider. Notice that when the 2-year/10-year spread turns negative, you’ll see a stock-market pullback highlighted by the shaded grey areas.

Janet Yellen, the Federal Reserve Chair, has addressed the flattening yield concern in her latest statements after the recent Fed meeting. “When the yield curve has inverted historically, it meant that short-term rates were well above average expected short rates over the longer run,” Yellen said. “Typically that means that monetary policy is restrictive, sometimes quite restrictive.”

But now, “it could more easily invert if the Fed were to even move to a slightly restrictive policy stance.” Yellen also remarked that market participants have not expressed concern about the flattening trend. “They see the odds of a recession as low,” she said, “And I’d concur with that judgment.”

For now, it’s important we monitor the yield curve and the major risks that can hinder the unprecedented growth the market has seen since November 2016. It’s not time to panic yet, however, as there are many positive economic data points that point to a healthy and growing economy. United States GDP continues to expand from its June 2016 low of 1.2 percent, to where it currently stands as of September 2017—at 2.3 percent and trending upward according to the latest Fed meeting. Other positive indicators include retail sales data (five-year high), consumer confidence trends (highs that we haven’t seen in over a decade), and 10-year highs in new home sales.

Leading economists, as well as economic data in recent months, have suggested that if the yield curve does continue to tighten and eventually reaches a point where an inverse to the yield curve occurs, meaning short term treasuries “out-yielded” long-term treasuries, an economic pullback would not be imminent. To quote Yellen in her recent press conference, “Now there is a strong correlation historically between yield curve inversions and recessions,” Yellen said. “But let me emphasize the correlation is not causation.” This means that just because two things correlate does not mean that one causes the other. At the same time, let us also remember Sir Thomas Templeton’s quote, “The four most expensive words in the English language are, ‘This time it’s different.’”