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Economic Forecasts

Flattening Yield Curve Doesn't Mean Imminent Recession

Kiplinger's latest forecast on interest rates

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GDP 2.9% pace in '18, up from 2.3% in '17 More »
Jobs Unemployment rate will decline further More »
Interest rates 10-year T-notes at 3.3% by end '18 More »
Inflation 2.4% in '18, up from 2.1% in '17 More »
Business spending Up 7% in '18, boosted by expanded tax breaks More »
Energy Crude trading from $60 to $65 per barrel in October More »
Housing Price growth: 5.0% by end of '18 More »
Retail sales Growing 5.1% in '18 (excluding gas and autos) More »
Trade deficit Widening 5%-6% in '18 More »

Short-term interest rates are rising faster than long-term rates, flattening the yield curve. The rate difference between the 10-year bond and the one-month bill this week fell below one percentage point for the first time since early 2008. Ramped-up Treasury Department borrowing is oversupplying the short-end market, which, coupled with the Federal Reserve’s cutback in purchases, is driving the trend. Concerns about an escalating trade war are also dampening the long-end a bit, and pension funds are buying a lot of 30-year bonds right now because of a tax break that expires in mid-September.

Some fear that an inversion of the yield curve is imminent, signaling recession. The curve becomes inverted when short-term rates are higher than long-term, which historically indicates an economic slowdown sometime in the next twelve months. In 2007 the Fed hiked short rates to combat inflation while the longer-term economic outlook became cloudy, depressing the long end and leading to the Great Recession.

However, today’s flattening is more technical in nature. The Fed’s normalization program requires lifting the short end first as it raises the federal funds rate and cuts back securities purchases. The federal government can always change the distribution of its borrowing pattern, too. Finally, trade wars can end as quickly as they begin, although this one could snowball.

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Long-term rates will move up, despite short-term volatility. Hiccups in the global stock market in the recent past stem from worries over the nascent trade war between the United States and most of the rest of the world, causing investors to seek bonds’ safety, dropping rates. But rising government deficits amid an expanding economy with slightly higher inflation should keep the market on an overall upward trend.

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The Fed is committed to raising short-term rates this year and next because it’s concerned about the tightening labor market. The Fed very much wants to stay ahead of any inflation that rising wages may generate and will lift short-term rates by a quarter of a percentage point twice more this year (after June’s hike). That would put the federal funds rate at 2.5% heading into 2019, when another three to four increases are expected.

We think today’s 2.8% yield on the 10-year Treasury note will hit 3.3% by year-end. The bank prime rate that auto loans and home equity loans are based on will bump up from 5% to 5.5%. The 30-year fixed mortgage rate is likely to go up to 4.8%, and the 15-year fixed mortgage rate should rise to 4.3%.

Higher interest rates are finally coming to savers. Although big banks have been slow to reward savers, rates on money market accounts and CDs at smaller banks, credit unions and online banks have picked up to nearly match rates on Treasury bills and notes.

Source: Federal Reserve, Open Market Committee

See Also: 27 Best Stocks for 2017