The Federal Reserve’s decision to cut interest rates just 25 basis points (bps) on July 31st was a mistake, given that the spread between the 10-year U.S. Treasury note and the federal funds rate was minus 32 bps at the time. Hence, a modest reduction of 25 bps was, and is, insufficient in generating a positively sloped yield curve that has had been flattening appreciably in a nearly uninterrupted fashion since 2014.
This is a problem because the yield curve is both a predictor, and creator, of recessions—something too few monetary policymakers seem to appreciate.
It is a predictor in the sense that a clamor to purchase long-duration government debt is a sign that investors do not fear unanticipated growth and/or inflation pressures. Instead, investors seek the safety of riskless government debt even if the returns are paltry. The “wisdom of crowds” has an impeccable track record of anticipating past recessions especially relative to the consensus of economists.
Additionally, an inverted yield curve means that the cost of short-term borrowing is more expensive than the return on lending as judged by the long-term rate, thus leading to less credit creation. In turn, this rationing of credit depresses economic activity.
Unfortunately for the Fed, long-term interest rates have continued to fall since their July 31 meeting, thereby inverting the yield curve to an even greater extent. Many investors attribute this to the possibility of a further ramp-up in tariffs on Chinese goods. Yet, this alone is off the mark for a couple of reasons.
One, Fed Chairman Powell was lukewarm on the need for further rate cuts, describing the 25 bp cut as “a mid-cycle adjustment to policy.” This precipitated a sharp decline in 10-year yields below the psychologically important 2 percent level, also causing the stock market to wobble. These factors led to the yield curve becoming more negative.
Not surprisingly, the trade-weighted dollar hit a new two-year high. This caused other central banks to respond, namely the Reserve Bank of India and the Central Bank of New Zealand. Each lowered interest rates more than market expectations. The Reserve Bank of Australia should follow suit and lower interest rates, too.
These actions have direct implications for the Fed, because as other central banks reduce interest rates, upward pressure on the U.S. dollar should persist if not strengthen. This poses other problems for the U.S. economy aside from the inverted yield curve. U.S. exports are likely to suffer. Unfortunately, it does not stop here.
Because the dollar has been particularly strong against emerging markets, demand for economically sensitive commodities will be dampened, at least for those countries not pegged to the greenback. This is evident in the sharp decline in oil prices. If this persists, it will dampen energy production and capital spending, thus creating yet another headwind to future U.S. growth prospects.
While some have been overly obsessed about the possibility of further U.S. tariffs on Chinese goods, the yield curve and the dollar have been suggesting monetary policy has been too tight for too long. Chairman Powell and his colleagues need to cut interest rates further and possibly aggressively so. The good news is that the fixed income and currency markets will tell us when the Fed has done enough. Stay tuned.
Joseph LaVorgna is the chief economist for the Americas at Natixis, an international corporate and investment banking, asset management, insurance and financial services arm of Groupe BPCE, the 2nd-largest banking group in France.