Some Like It Hot (The Economy, That Is)

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"I would be open to some of what you might call running the economy hot if you were talking about a relatively mild form of that idea that is not really risking undesired inflation rising rapidly."

- Atlanta Fed President Dennis Lockhart, 4 November 2016.

After years of facing intentionally low interest rates, investors may be somewhat surprised to learn that Lockhart's comment above actually reflects the latest thinking out of the Federal Reserve (Fed). That is, the idea of running the U.S. economy "hot" to bring about further gains in employment. Fed Chair Janet Yellen officially kicked off the debate over the merits of such an approach in an October speech to the Boston Fed.

Why is this important to investors?

Most obviously, because the current thought process impacts the market's expectations for how monetary policy will evolve. But that also has great significance for the market's actual performance. And one of the most frequently asked questions we get from the financial advisor community is this: Will Fed "normalization" result in an inverted yield curve? And if so, when?

Yield curve inversion happens when yields on longer-term bonds have a lower yield than shorter-term securities. It is commonly viewed as a sign that an economic recession is on the way, so it's no wonder advisors have that question on their minds. Simply, the yield curve inversion has been your best "sell signal" for the stock market.

Is the past prologue?

Take a look at the chart above. Consider that the experience in the stock market in the last three decades has been characterized by three bubbles and two busts. Those last two busts were best signaled by the Fed's policy actions and the market's expectations for them. The textbook response to a Fed normalization cycle (indicated on the chart as an increasing federal funds target rate) is greater increases in short-maturity interest rates relative to long-maturity rates (a "flattening" in bond parlance). When this reaches an extreme, short-term interest rates are higher than longer-term rates, indicating market concern that the tightening of policy might end up pushing the economy into recession.

But the fact that the last two Fed normalization cycles led to yield curve inversions does not mean this always will be the case. The key is how the Fed weighs the tradeoffs of its dual mandate: stable prices alongside maximum employment. Critical to those past experiences was the relative importance the Fed attached to stable prices; what Yellen proposes in effect are arguments that support shifting the importance to maximum employment. To the extent the Fed follows through with such policies and to the extent the market believes this to be the case, we should expect the market reaction - and therefore any curve reaction - to behave very differently than in past cycles.

To wit, rather than expecting the curve to flatten, we expect it to steepen. While we have highlighted a global steepening of yield curves as the European Central Bank (ECB) and Bank of Japan (BOJ) move away from coupling quantitative easing with negative interest rate policy as one reason, running the economy "hot" represents another critical reason for this atypical market reaction to Fed normalization. And the anticipation of greater fiscal policy support post-election represents another. But for those looking for this most favorite of tea leaves - the yield curve - to tell them when to sell their stocks, it may be better to look elsewhere. For more market insights, read my fixed income monthly.

This post originally appeared on the BlackRock blog.