And then the yield curve inverted. As if a verse out of the book of Genesis, yield curve inversions generally predict financial plagues of Biblical proportions. This is how nearly all economic horror stories of the past several generations have begun. On Monday of this week, the U.S. government's five-year bond yielded less interest than the three-year bond. In other words, bond holders were okay with being paid less to tie up their money longer with the U.S. government. Normally the longer term a project or a financial investment, the higher the return, simply because there is more uncertainty and thus more risk. This inversion of the yield curve spooked investors Tuesday with a bloodbath taking place across financial markets.
In an "economic letter" published by the San Francisco office of the U.S. Federal Reserve (Fed) , Michael D. Bauer and Thomas M. Mertens summarize the implications of an inversion succinctly: "Every U.S. recession in the past 60 years was preceded by a negative term spread, that is, an inverted yield curve. Furthermore, a negative term spread was always followed by an economic slowdown and, except for one time, by a recession. While the current environment is somewhat special - with low interest rates and risk premiums - the power of the term spread to predict economic slowdowns appears intact."
Should this harbinger of bad news hold, the U.S. economy is almost certainly looking at a slowdown if not an outright recession. The Fed is keenly aware of this and may react in one of two different ways at its upcoming policy meeting. The Fed may try to reassure markets that the economy is doing well and that it is not worried by continuing with their planned rate hike of a 25 basis points or they may single a delay of the hike. Delaying the hike would reinforce the markets fear and prove that the Fed also fears a slowdown. A rate hike however, while signaling confidence by the Fed, would continue to make financing more expensive for firms and households. This may, in turn, lead to lay-offs and a slowdown in employment and growth and ultimately force the Fed to cut rates to spur the economy.
A precarious situation for the Fed undoubtedly and one that I believe they will be forced to respond to with either an outright suspension of rate hikes for the next six months - potentially skipping the expected rate hike this meeting as well - or with a rate hike accompanied by very strongly worded assertions that the Fed will not raise rates again for an extended period of time and that rate hikes may themselves be in store in the very near future.
Whatever the situation with the Fed and the U.S. markets, emerging markets may be effected even more than the U.S. economy. A hint at rate cuts coming down the pipeline would offer much needed breathing room for emerging market (EM) currencies and move funds from U.S. government bonds to other havens of interest returns causing them to appreciate against the dollar.
Will the Fed risk triggering an economic recession especially during this period of political turmoil and uncertainty? I'm doubtful. Look for the Fed to skip this rate hike and reassess after the new year.