Curious about the ins and outs of it all? Check out the New Fed Hawks War Room above.
I. The Skinny: New Fed Hawks – Why Ripe?
2018: New Fed chair, rising volatility, and the flattest yield curve in a decade. The Fed is back in the spotlight as it deals with short-term rates exceeding long-term rates. In the New Fed Hawks War Room HiddenLevers co-founders Praveen Ghanta and Raj Udeshi explore the predictive powers of the inverted yield curve.
II. Scenario Update
The Good: Old Normal
Under our good scenario, GDP and the 10-year Treasury would continue traveling, GDP pulling up the 10-year. This bring up the market with double-digit moves up by 12%. GDP up be up at 3.1% and 10-year slightly higher than today at 3.25%.
The Bad: 1987 Crash Repeat
We are closest to this scenario. If the Fed becomes aggressive with rate hikes and pierces the asset price bubble, fixed income would become more attractive, moving investors away from equity. The S&P would be down 20% and GDP down 2.5%, and the 10-year at 3.5%. This is not a recession scenario (the economy is still growing), but there would be a sharp correction.
The Ugly: Inverted 2/10 Yields
With an inverted yield curve, the 10Y would stay relatively flat at 3%, but the 1-year rate would be up to 3%. This would mean a negative 2/10 spread, which correlates to recession. The typical impact of recession that follows an inversion would bring the S&P down -35% and GDP down -.5%.
III. New Fed Hawks: The Takeaways
Time Lag = 1y Between Yield Curve inversion + Recession: On average there is about a one-year lag between when the yield curve inverts and when a recession occurs as shown by the chart above. Throughout history the correlation between these events highlights the predictive power of the inverted yield curve.
2-3 more hikes inverts yield curve: Even with the recent rise in 10Y Treasury, the 2/10 Treasury Spread is only around 50 basis points. This means if the Fed were intent on even two rate hikes for the remainder of the year, this would bring us to a flat or possibly inverted yield curve. With not much room to move, these rate hikes would bring us closer to a possible market correction.
Why are we raising rates if no inflation?: The Fed is raising rates with no inflation in sight. With the New Fed Hawks led by Jerome Powell there’s a heavy assumption there will be strong GDP growth and rates will be able to keep up. Since July 2016 business friendly policies keen on growth have given hints of returning to the “old normal,” and the more hawkish tone of the Fed is okay with letting the economy run hot to bring that back.
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