The Bell Curve Is About Policy. And It’s Wrong.

Here's the message of the rapidly flattening Treasury yield curve: Financial markets are signaling that the Trump Fed is wrong for the Trump tax cuts and Trumponomics.


The flatter Treasury yield curve reflects investors curbing their expectations about the strength and durability of the nascent Trump economic boom, with tighter Fed policy as a prime reason.

The last thing Trump wanted in a central bank chief was someone who would speed up Fed rate hikes to stem a tax-cut-fueled economic surge. But that's exactly what he got.

Chairman Jerome Powell's Fed penciled in a total of four rate hikes in 2018 at the June Fed meeting, one more than in March. Powell said the economy was in "great shape" at this post-meeting press conference.

The spread between the two-year Treasury yield and 10-year Treasury yield has narrowed to just 24 basis points. That's the smallest gap since before the recession hit in 2007. That's down from an already-tight 42 basis points before the June 12-13 Fed meeting. For now, the Fed is eyeing another three hikes in 2019.

Morgan Stanley predicted last week that the Treasury yield curve will invert next year, a reliable precursor to recession. Yet so far, Powell and most other Fed policymakers are taking Treasury-yield-curve flattening in stride.

Powell didn't mention the Treasury yield curve in prepared testimony on Tuesday. In June, he noted that "arguments are made that a flatter yield curve has less of a signal embedded in it" about the neutral level of interest rates. Powell added that yield curve flattening is the natural result of the Fed raising short-term rates.

Yet it also appears that tighter Fed policy is putting downward pressure on long-term Treasuries. The two-year Treasury yield is up 7 basis points since June 12, the day before the Fed's statement. The 10-year yield is down 10 basis points since then.

Federal Reserve Is World's Central Bank

The Fed is the closest thing to a global central bank. Tighter Fed policy, higher short-term rates and a stronger dollar all tighten financial conditions in emerging markets, where companies often borrow in dollars.

This dampens the global growth outlook and puts downward pressure on global bond yields, creating more demand for U.S. long-term debt.

Meanwhile, higher short-term borrowing costs via the Fed weigh on U.S. multinationals' profits via a stronger dollar, squeeze bank lending margins and raise the cost of adjustable-rate mortgages.

With a lag, Fed policy will work to rein in the Trump boom. Yet as tighter monetary policy begins to bite in 2019, this year's big burst of federal tax-cut and spending stimulus will quickly level off.

This also may help explain the suddenness with which the Treasury yield curve has flattened. Looking out past 2019, the questions for the economy multiply. More and more economists are predicting recession in 2020 and the U.S. will have to reckon with unimaginable budget deficits.

It's worth remembering that last August, before the legislative push for tax cuts gathered steam, financial markets were pricing in just a single quarter-point Fed rate hike over the ensuing 12 months.

That might have been an overreaction to tame incoming inflation data. But 11 months and three rate hikes later, the Trump Fed is now penciling in five more rate hikes over the next year and a half — despite Trump trade wars breaking out all over.

While Powell noted the economic support of federal tax and spending policy in Tuesday remarks, Trump Fed policy discussions have largely ignored the unprecedented nature of Trump's decision to gun the fiscal accelerator with the jobless rate around 4% and falling.

A Trump Fed Chief For Trumponomics

Trump may have been better served by a Fed chief who was a big believer in supply-side tax cuts to boost business investment, speed up productivity growth and keep inflation in check. At the least, he might have picked a Phillips curve skeptic, questioning the historic links between lower unemployment and higher wage growth. Or he could have found someone who believes the forces of technology and globalization make a big bump in inflation extremely unlikely. Finally, he might have found someone who doesn't think the Fed should try to target asset prices.

Instead, the Trump Fed is using its usual playbook to meet an unprecedented challenge. The Treasury yield curve flattening should be a wake-up call, but risks will rise until Powell and other Fed policymakers answer the bell.

In a weekend note, UniCredit Group Chief Economist Erik Nielsen wrote of the "likely folly in dismissing the signal from a curve, which is on its way towards inversion."

"Historically, growth starts to slow about a year before recession in the U.S., and the Fed stops hiking around the same time," Nielsen wrote. "This makes me wonder if we'll get any Fed hikes at all in 2019!"

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