“There is a material risk of yield curve inversion over the forecast horizon if the FOMC continues on its present course of increases in the policy rate. It is possible that yield curve inversion will be avoided because longer-term nominal yields will begin to rise in tandem with the policy rate, but this seems unlikely as of today. Given below-target U.S. inflation, it is unnecessary to push normalization to such an extent that the yield curve inverts.“ (James Bullard, Assessing the Risk of Yield Curve Inversion, Regional Economic Briefing Little Rock, Ark, Dec. 1, 2017)

On December 13th the U.S. Federal Reserve increased its key policy interest rate for a third time in 2017. The markets were well prepared for the latest rate hike, which brings the top range for the federal funds rate to 1.5%.

This much anticipated policy move immediately raised short term Treasury yields, but the upward shift at the short end was not matched by an increase in longer-term Treasuries.

While some further flattening out of the yield curve was widely expected, it also has raised concerns that at some point next year the yield curve could invert, resulting in a new recession.

Historically an inverted yield curve (which has a 2-year yield above a 10 year or 30-year Treasury bond yield) has heralded most economic downturns since the middle of the last century. However, as James Bullard of the Federal Reserve observed in a recent speech, history does not always repeat itself in the same way.

In most cases when the yield curve inverted, the Fed deliberately chose to cause a downturn, if not a mild economic slowdown. Currently the Fed has no desire to cause a recession, since the legacy problems from the last Great Recession are still evident around the world.

The Fed currently is pursuing normalcy in financial markets, rather than a new recession. As long as the Fed continues to warn the markets long in advance of future rate hikes, there seems to be no obvious easy reason to expect a Fed induced recession.