The Fed cut the fed funds target rate from 5.25% on 9/18/07 to 0%-0.25% on 12/16/08, where it remains to this day. During this same time, the yield on the 10-year note sank from above 4.50% to below 1.5%, and now hovers below 2.2%.
Since 1948, the yield on the Fed funds rate averaged 1.4 percentage points above the year-over-year percent change in CPI (headline from 1948-1956, and Core thereafter). Core CPI currently stands at 1.8%.
Knowing that the Federal Reserve controls the short end of the yield spectrum, and that the market controls the long end, does the Fed’s overly accommodative monetary policy mask what would otherwise be an inverted yield curve? If so, does this imply that a bear market is just around the corner?
Under normal circumstances, an annualized core CPI at 1.8% would imply an effective fed funds rate of around 3.2%. Compare this with an abnormally low 10-year yield of 2.2%, and one can’t help but come to the conclusion that the Fed is masking an inverted yield curve. Yet today’s low inflation rate, combined with the actual yield curve, tell a different story.
One reason is that whenever inflation was below 2%, the yield curve never inverted. What’s more, the yield curve, or the difference between the market-driven 10-year yield and the Fed-influenced 3-month yield, is actually steeper today than its average since 1948.
Thus, we believe that today’s low 10-year yield, relative to inflation, is not assisting the Fed in masking an invisible inversion, but is a reflection of a half-speed economy that we think is more likely to accelerate than stall out.