FORECASTS & TRENDS E-LETTER

by Gary D. Halbert

June 13, 2017

  1. Policy Committee Set to Hike Fed Funds Rate Tomorrow
  2. Yield Curve Flattening – Could It Invert in the Next Year?
  3. CNBC Writer Predicts Inverted Yield Curve This Year
  4. Trump Should Cut Corporate Taxes First, Wait on Infrastructure

Overview

The Fed policy committee will almost certainly raise the key Fed Funds rate by another 0.25% tomorrow. Minutes from the early May Fed meeting indicate that the Fed sees the 1Q economic weakness as temporary, and the odds for a rate hike tomorrow are above 90%.

The so-called “yield curve” – the spreads between yields on short-dated Treasuries (notes) and longer-dated Treasuries (bonds) – have been narrowing most of this year, and analysts wonder if this trend is likely to continue.

Some worry we may be looking at an “inverted yield curve” where short rates rise above long rates before too long. Inverted yield curves are bad for the economy and have preceded the last seven recessions. We’ll look into this issue as we go along today.

Finally, I’ll summarize the latest article from CNBC’s Larry Kudlow, one of my favorite financial writers. He met last week with top Trump officials and presented them with a plan for how to move their economic policy forward in the wake of James Comey’s controversial Senate testimony last week. I like the plan and I think you will too. Let’s get started.

Policy Committee Set to Hike Fed Funds Rate Tomorrow

It is widely expected that the Fed Open Market Committee (FOMC) will raise the target range for the Fed Funds rate by 0.25% from 0.75%-1.00% to 1.00%-1.25% at the conclusion of tomorrow’s policy meeting. It will be the second rate hike this year following the last bump in March. Fed Funds futures put the odds of a rate hike tomorrow at over 90%.

Yield Curve New Recession

Some analysts argue that the Fed should not raise the rate tomorrow citing the weak GDP growth of only 1.2% in the 1Q and the disappointing May unemployment report which showed only 138,000 new jobs versus 185,000 expected. Yet the minutes from the last FOMC meeting on May 2-3 suggested the Fed considers the weak 1Q GDP to be temporary.

Given that, it will be a big surprise tomorrow if the FOMC does not raise the Fed Funds rate.

Most Fed-watchers expect the FOMC to raise the Fed Funds rate by another 0.25% at the September policy meeting if the economy continues to expand at a reasonable rate. There is even talk of another rate hike in December, but the FOMC meeting minutes have made no such suggestion specifically.

Yield Curve Flattening – Could It Invert in the Next Year?

The so-called “yield curve” is simply the spread between yields on short-dated Treasuries (notes) and longer-dated Treasuries (bonds). The spreads have been narrowing most of this year, and analysts wonder if this trend is likely to continue.

Some even worry that we could see an “inverted yield curve” – where short-term rates climb above long-term rates – later this year or early next year. Inverted yield curves are almost always bad for the economy.

In fact, inverted yield curves have preceded each of the last seven recessions dating back to the late 1960s. This is because bank lending dries up during inverted yield curves when their income off of longer-term loans falls short of the interest they pay on short-term deposits. So they just stop or cut back significantly on lending.

The decline in lending almost always leads to higher interest rates, and this is bad for the economy – which is in turn bad for the stock markets. Given that our equity markets are arguably in a bubble, an inverted yield curve could be devastating, especially if it lasts very long.

The last two times the yield curve inverted was in the years 2000 and 2006. The 2000 inversion and subsequent recession caused NASDAQ stocks to plummet 80%. The 2006 inversion helped cause the Great Recession in which the S&P 500 dropped over 50% and home prices fell over 30% in many parts of the country.

Let’s take a look at where we are on the long end of the yield curve now. The first chart below is the yield on the 10-year Treasury Note that ended last week at 2.20%. As you can see, yields on the 10-year have been trending lower since March.

Yield Curve New Recession

The next chart is the yield on the 30-year Treasury Bond that closed last week at 2.86%. So the spread between them has narrowed to 0.66%.

Yield Curve New Recession

With the Fed expected to hike its short-term rate tomorrow and again in September or December (or both), there is speculation that the 10-year yield could overtake the 30-year later this year, thus inverting the long end of the yield curve.

CNBC Writer Predicts InvertedThis Year

While I doubt the Treasury will let the 10-year yield overtake the 30-year, to the extent it can control it, speculation about an inverted yield curve intensified following a June 5 column in CNBC written by Michael Pento, a guest contributor.

Mr. Pento believes that the yield curve will invert by the end of this year and warns that it will usher in a “brutal” new recession next year. He believes this will be very negative for stocks, bonds and real estate – each of which he considers to be in a bubble.

Mr. Pento’s concern is different from the 10-year/30-year discussion above. Mr. Pento is in the camp that believes the 10-year Treasury yield will continue to fall, and will fall more than is currently expected. He expects the 10-year Treasury yield to fall this year to 1.35% where it was in July 2015.

Meanwhile, he believes the FOMC will continue to raise the Fed Funds rate at least as much as is currently expected.

Yield Curve New Recession

Thus, he sees the Fed Funds rate (blue line) overtaking the 10-year yield (yellow line) by the end of this year. He believes the FOMC will have to raise the Fed Funds rate more than expected in 2018, thus making the inversion even worse and longer-lasting.

This, Pento believes, will lead to a serious recession in 2018 which will usher in the next bear market in stocks, bonds and real estate. He says the only way to avoid an inverted yield curve by the end of this year is if the US economy improves significantly just ahead.

Yet the only way he sees that happening is if President Trump gets his policy agenda – tax cuts, deregulation, infrastructure spending and repatriation of foreign profits – adopted soon. But as we all know, the odds of that happening are getting lower by the day.

In conclusion, I included the discussion above today, not because I agree with Mr. Pento’s forecast. I do not believe it is the most likely scenario. I included it because it can’t be ruled out and adds another perspective on the increasing discussion of an inverted yield curve.

Trump Should Cut Corporate Taxes First, Wait on Infrastructure

Many if not most political observers agreed

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