Tightening Cycles - A Brief History
In the past twenty-five years, there have been four distinct periods of uninterrupted Fed tightening, each with unique characteristics. For example, the 1994-95 period was nasty, brutish and short (apologies to Hobbes), and sparked by an inflation impulse that proved to be overblown. The tightening process ended quickly and the Fed actually cut rates in mid-1995. Then the late nineties brought on the Dot Com stock market bubble which then-Chairman Greenspan saw as irrationally exuberant. The subsequent tightening cycle was another short one with just a year and a half between the first rate hike and the beginning of the next easing.
In the wake of the 2001 recession, the Fed took the Funds rate to just 1% (shockingly low at the time). The subsequent recovery began quite normally, but eventually brought back asset-price exuberance. This time it was in the form of mortgage lending and an overheated housing market, and it eventually morphed into a major financial crisis. As this was developing, the Fed had begun to tighten and eventually took the Funds rate to its 5.25% pinnacle after twenty-seven months of steady rate hikes. When the house of cards collapsed (Lehman, Fannie/Freddie, et al.), we saw the mother of all post-war recessions followed by a grinding recovery, first painfully slow but finally heating up in recent years. At the end of 2015, a year after halting the asset purchases of “quantitative ease,” the Fed decided it was time to begin raising rates. Now eight rate hikes later, we may be getting close to the end of yet another policy phase.
Yield Curve Slope and The Way Forward
So, what’s been notable about this tightening cycle? We have now completed three years of uninterrupted increases in overnight borrowing costs in the banking system. The duration of this rising rate period is therefore the longest in at least a third of a century. Not a year and a half, not twenty-seven months, but we’ve now seen increases in the Fed Funds rate for three years, and until very recently the Fed has told us to expect additional hikes in 2019. This unusually long duration of tightening could be justified as a mirroring of the equally unusual duration (and unprecedented nature) of the easing cycle from 2008 to 2015. But it’s also possible that we’ve seen a familiar overreach by the Fed, and that possibility can be seen in the recent behavior of the yield curve.
Let’s remember that short-term rates dance to the beat of Fed policy, moving higher or lower in sympathy with the current funds rate, while yields in the longer end of the maturity spectrum are focused on expectations of future growth and inflation. When the curve is steep, the market has priced-in the expectation that coming years will see rising rates due to a positive growth outlook and upward pressure on inflation. As the curve flattens, it indicates that market expectations are for weaker growth and lower inflation. So, what’s the curve suggesting today?
As we move toward 2019, the yield difference between 2-year and 10-year T-Notes is just 10-12bps, a far cry from the 266bps difference five years ago. And some parts of the curve, say Fed Funds to the 5-year, have already inverted. If history repeats itself, this ultra-flat, partly inverted curve tells us we can expect slow, and possibly negative, growth for the economy in the coming year. That, in turn, may mean that Fed policy will reverse course and push rates lower. Only time will tell, but bank managers may be well advised to prepare for lower, not higher, rates in the coming year.