Here is what’s going on with the yield curve

Bond markets are not convinced that the Federal Reserve has done enough

The Federal Open Market Committee has foreshadowed a lengthy pause in the programme of US monetary easing that has been under way throughout this calendar year. Instead of significantly raising policy rates, as promised when the year began, there have been three “insurance” cuts of 25 basis points in US rates since midsummer.

In his press conference on Wednesday after the latest cut, the Federal Reserve chairman Jay Powell claimed that this adjustment has left US monetary policy “in a good place”. The Fed offered no guidance about the likely direction of the next move in rates, which it says will be determined by new economic data in coming months.

Mr Powell was asked whether he believes that the US monetary policy stance is now “accommodative”, which is a way of asking whether the Fed is seeking to encourage faster growth and higher inflation.

His nuanced answer was that it is “somewhat accommodative” and is “appropriate” to support the Fed’s economic outlook. He added that there is a range of plausible estimates for America’s current “equilibrium” interest rate — which neither boosts nor slows the economy. He also specifically mentioned that these estimates are still being revised downwards.

If developments emerge that cause a material reassessment of our outlook, we would respond accordingly. But, that’s what it would take, a material reassessment of our outlook.

Fed chairman Jay Powell, October 30

This raises a very interesting issue. The recent behaviour of bond yields suggests that the market is less confident than the FOMC that monetary policy is at the moment either “accommodative” or “appropriate”.

Rather than seeing the rate cut as providing additional stimulus to the economy, the market seems to believe that the equilibrium rate has fallen and the rate cuts are an effort by the Fed to catch up with it.

This is best observed in the Treasury inflation-protected securities or Tips market, where investors directly trade real interest rates on government debt (see Graph 1 below). The decline in real long-term rates in Tips (a proxy for the equilibrium rate) has been very similar to the drop in real policy rates since the Fed changed tack and started easing monetary policy in January.

If investors believed the rate cuts were going to spur growth, long-term rates should have risen relative to short-term rates and the yield curve — which shows the difference between short-term policy rates versus long-term bond yields — should have become steeper. Instead, the yield curve in the Tips market has changed very little.

What is going on? One plausible interpretation is that the market has become more concerned about chronically low growth, or “secular stagnation”, in the global economy in 2019.

As Lawrence Summers and Lukasz Rachel have argued in new research, global equilibrium interest rates have been falling precipitously for several decades, especially in the private sector. It is possible that this decline was temporarily arrested during the economic upswing of 2016-18, helped by the US fiscal stimulus, but has now reasserted itself.

Messrs Summers and Rachel believe that, in the absence of major new policy initiatives to reduce private savings, boost private investment and increase budgetary stimulus, the equilibrium real rate of interest may well become negative in the advanced economies.

The bond market seems to have some sympathy with this point of view, even in the US, where the case for secular stagnation seems weaker than in Japan or Germany. During the latest economic slowdown, the US bond market appears to have reduced its estimate of the equilibrium real rate from around 1 per cent to an average of about zero in recent months (see Graph 2 below).

Much of this downward shift may have stemmed from concerns about whether interest rates in the eurozone and Japan can remain persistently below zero. With interest rates stuck near the zero lower bound in those economies, world policy rates may be too restrictive. This may, in turn, be exerting strong downward pressure on the US economy and its equilibrium real interest rate.

On this interpretation, the Fed may have raised US policy rates too much during 2018 and has since been forced to play catch-up by following global equilibrium rates downwards without being able to ease its effective monetary policy stance much this year.

Mr Powell would prefer not to believe this pessimistic tale, but he cannot relax until the US has clearly avoided the low real rate trap that has engulfed the eurozone and Japan. Fed delivers third rate cut but signals it is done for now


The US yield curve has not reflected the Fed’s easing cycle


The US economy has slowed sharply since the end of 2017. Fed chairman Jay Powell pointed out last week that the FOMC has responded with a cumulatively very large decline in interest rates, relative to what was expected at the beginning of 2019. Short-term interest rates have fallen by 75 basis points, and are now 150 basis points below the level expected by the Fed a year ago.

US real economic growth



The yield curve usually steepens when the central bank eases monetary policy, because the short-term end of the curve reflects the decline in policy rates, while the long end remains fixed at close to the assumed long-term equilibrium interest rate in the economy.

However, on this occasion, long-dated yields have fallen fully in line with the decline in short rates, so there has been a parallel downward shift in the entire yield curve, with no sign of steepening as policy has been eased. This is best seen in the behaviour of real yields in the TIPS market.

Real US interest rates in the US TIPS market


Why has the curve behaved in this manner? One explanation is that the market has adjusted downwards its estimate of the real long-term equilibrium yield, while the Fed has simply followed this decline in its policy rates. With the equilibrium yield and the policy rate both dropping by similar amounts, the impact of policy rates on the economy appears to be unchanged.


Real policy stance as reflected by interest rates in the US TIPS makret





Source: This note is based on material which appeared in an article by Gavyn Davies published in the Financial Times on 3 November 2019.
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