Fed’s Interest Rate expectation policy and yield curve inversion

The market doesn’t like surprises, and the Federal Reserve is not going to give any. The Federal Reserve has moved to clearly signal interest rate policy, lest the market has any panic with unexpected moves.

The current Fed Fund rate of .30% does not reflect their intentions going into the future. Some believe that a better representation of monetary policy is the 2-year treasury rate, currently priced at 2.43%. These rate levels are currently priced into the expectations of the bond and equity markets.

In the US mortgage rates are generally priced as 30-year fixed rates. Since December 2021, the 30-year mortgage rate has moved from 3.24% to currently 4.91%. In Australia, the floating rate mortgages are still based on the RBA’s zero interest rate, but in 12 months’ time the futures market expect the cash rate to move to 2.25%, moving home mortgage rates to between 4.25% to 5%.

Yield Curve Inversion

The normal expectation of the market is that short-term interest rates are lower than long-term interest rates (ie a normal yield curve). When a yield curve inverts, i.e., short-term rates are higher than long-term rates, the expectation is that the economy will move into recession. Most recessions have been preceded by yield curve inversion, but not all yield curve inversions have been preceded by a recession.

We have charted each of the interest rate maturities (3-mth, 2-year, 5-year, 7-year) to the 10-year bond rate (see below). You can see that as the shorter-term rates rise above the 10-year rate (i.e., the difference between the two rates moves to zero), the likelihood of recessions rise.

It was a reasonable possibility that the world’s economy was moving into recession in 2019, prior to Covid.

The consensus seems to be that if interest rate moves toward or beyond 3% then there is a great possibility of a downturn in the highly indebted housing market. Between the Ukraine war, food shortages, fertilizer shortages, rising oil and commodity prices causing inflation to move much higher, combined with constrained wage inflation, the net effect will be falling real wages.

The solution (if you can call it that) will be more money printing and capping interest rate rises. The risk of a hard landing is rising.