The Federal Reserve is on the cusp of making its biggest policy mistake in modern times and it is seemingly unaware of the damage it is about to cause. Despite appearances of a robust labor market, rising corporate profits, and high asset prices, the underlying economy is rather weak. For many Americans, high inflation is creating an increasingly large financial burden.
For the Federal Reserve, tackling the inflation beast is a top priority, regardless of the collateral damage it may cause. Inflation is not just a financial burden to many American households, but it also threatens to shake up the current political landscape.
Voters tend to oust the majority party when they feel policymakers have left them impoverished, and with the midterms coming later this year, the probabilities of a changing of the guard are high. President Biden and Congress have tasked the Fed with putting out this inflationary fire as quickly as possible.
The challenge for the Fed is how to douse the inflationary fire without sending the economy into a recession. Given every Fed tightening cycle has led to a recession, the odds the Fed can successfully navigate these unfriendly waters is somewhere close to zero percent. In the Fed’s defense, the sure-fire way to deal with inflation is to send the economy into a deep recession by crashing asset prices.
Treasury yields are already suggesting the Fed is making a massive policy mistake that will send an already weak economy into a deep recession at best, or another financial crisis. There is not a more accurate signal of an impending financial disaster than Treasury yields, especially when they are teetering on the edge of a collapse. When yields collapse, it tends to take stock prices and the economy with them.
When Treasury yields are positively slopped across the curve where short-term yields are lower than long-term yields, it signals that growth expectations are higher than inflation expectations. From an economic perspective, this is a positive indicator of future growth. As long as long-term yields continue to rise at a faster rate than short-term yields, it further validates future growth expectations.
When inflation starts to rise, short-term Treasury yields are likely soon to follow as an indication of rising inflation expectations. While 2-year Treasury yields tend to follow consumer prices higher, they are not perfectly correlated in their movements. When 2-year Treasury yields rise, they tend to pull longer-term Treasury yields higher with them.
As long as yields across the Treasury curve are rising as 2-year Treasury yields press higher due to inflation, it means that growth expectations are outpacing inflation expectations. Warning signs begin when 30-year Treasury yields begin to rise at a slower pace and start to flatten out despite rising short-term yields.
When the long end of the Treasury curve stops responding to rising rates, it indicates that growth expectations are diminishing as inflation continues to rise. It is not until the long end of the Treasury curve begins to equal or, even worse, start to invert against other parts of the curve that problems start to manifest themselves.
When parts of the Treasury curve invert, meaning yields of a longer tenor are lower than that of a shorter tenor, it indicates that growth expectations are falling below inflation expectations. When growth expectations are below inflation expectations, it indicates future economic growth, at best, is going to stagnate and potentially decline.
When economic growth is insufficient to keep pace with inflation, the economy tends to slow, which could lead to an outright recession if either growth slows too much or inflation rises too much. The probabilities of a recession rise as further parts of the Treasury curve flatten out or worse, invert.
In late October 2021, 30-year Treasury yields dipped below 20-year Treasury yields, and have remained inverted since. According to the Treasury curve, inflation is outpacing long-term growth expectations. To make matters worse, the belly of the Treasury curve began to flatten in February as 5-, 7-, and 10-year Treasury yields converged.
When short- and intermediate-term Treasury yields begin to converge with the long end of the curve, it indicates inflation is about to overwhelm growth expectations over the short, intermediate, and long term. Historically, when the Treasury curve converges near a given rate, Treasury yields are soon to collapse.
A converging Treasury curve indicates that inflation is rising faster than growth expectations, and that financial conditions are tightening. Typically, the long end of the curve will first decline, which will cause various parts of the curve to flatten or invert. As more parts of the curve flatten or invert, yields across the entire curve often nosedive.
Currently, the front end of the Treasury curve is racing higher as the long end of the curve is beginning to roll over. The Treasury curve indicates inflation will eat into intermediate-term and long-term economic growth. As a result of this convergence of the Treasury curve, yields will soon collapse and take the economy down with them.
