As many of you have probably heard, the flat yield curve we’ve been keeping our eyes on actually inverted March 22 — for the first time since 2007. The inversion of the yield curve occurred after the Federal Reserve announced that it does not plan on raising short term rates for the rest of 2019, and that it plans to stop reducing its balance sheet — a move that typically would force long-term rates downward.
Following the Fed announcement, the yield on 10-Year Treasury Bonds fell to 2.428 percent, pushing it briefly below the yield of the 3-Month Treasury Bill at 2.453 percent. An inversion to this part of the yield curve has long been seen as a reliable indicator of a possible recession on the horizon.
Many market followers believe that it was the bond market’s anticipation of a recession that caused long-term rates to drop precipitously. That may be a small part of the reason, but what no one is talking about is that by definition, as we’ll talk about later, the move the Fed made, in and of itself, pushed long-term rates down.
While the way the Federal Reserve has handled the manipulation of short-term interest rates is shocking to many, it makes me wonder…what in the world is the Fed thinking?
It’s almost as if the Fed is intentionally trying to create a recession by flattening the yield curve. Or, maybe they’ve spent so much time looking at their dot plot that they can’t see the big picture.
I imagine it’s similar to what happened to Eastern Air Lines Flight 401 in 1972. The pilots and flight crew became so preoccupied with a burnt-out landing gear indicator light that they didn’t realize the plane’s auto pilot had been inadvertently disengaged. As a result, the plane gradually lost altitude until it crashed into the Florida Everglades.
So, it could be that the Fed is so focused on its dots that it doesn’t realize that what it’s doing could cause the economy to come crashing down. With so many smart people on the Federal Reserve Board, however, I find it hard to believe, but it’s certainly possible.
Here’s How It Works
Here’s where the Fed’s plan to slow down and stop the reduction of its balance sheet comes in to play. One of the monetary tools the Fed has at its disposal is its balance sheet. During times of Quantitative Easing (QE), the Federal Reserve buys Treasury Bonds and Mortgage-Backed Securities in order to pump more money into the banking system, which in turn helps keep interest rates low. This is known as expanding the balance sheet.
The problem is that the Fed’s QE efforts that followed the stock market crashes in 2000 and again in 2007 helped their balance sheet expand to an unprecedented $4 trillion. As a result, the Fed has been reducing the size of its balance sheet, which it does by selling Treasury Bonds.
But, in March when the Fed announced it would slow down the reduction of the balance sheet and would end it in September, it means they’ll stop selling Treasury Bonds, and this will result in a reduction to the supply of bonds available in the market.
When the supply of bonds is reduced, but demand stays the same, the prices of bonds go up. And, as you know, when prices of bonds go up, their yields, or the interest they pay, goes down.
So, essentially, the way the Fed is managing the monetary policy tools at its disposal actually caused long-term interest rates to come down and result in a further flattening of the yield curve.
Why That’s Bad
When the difference between short-term and long-term interest rates is so slim, banks end up paying depositors almost as much in interest as they take in from the loans they give out — which basically takes away banks’ incentive to lend. This results in a reduction of money circulating in the economy and could cause a ripple effect that brings the economy to a grinding halt.
So, the question becomes, why would the Fed want to create a flat yield curve? Well like any good detective would ask, “What would be the motive for causing a recession?”
I don’t know, maybe a Federal Reserve that’s tired of being criticized and second-guessed, and wouldn’t mind seeing a certain President lose his bid for re-election in 2020? I don’t know…that’s just too crazy to fathom….
Check back next month as we consider more thought-provoking ideas that might be a little too edgy for my show, "The Income Generation."
David J. Scranton, CLU, ChFC, CFP, CFA, MSFS, is a nationally renowned money manager, Amazon Bestselling author, national TV host of Newsmax TV's "The Income Generation," founder of Sound Income Strategies, LLC, and CEO and founder of Advisors’ Academy. With over 30 years of experience in the industry, Scranton specializes in income-generating savings and conservative investment strategies.
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