The Federal Reserve is clearly and plainly telling us that it intends to take the US into recession in short order. I'm not sure what message the markets are hearing, but the Fed is messaging two to three more rate hikes this year into (according to GDP) a sluggish and slowing economy.
The FFR (Federal Funds Rate) has been raised by 80 basis points and meanwhile the 10yr US Treasury yield has flat-lined. At this pace, the spread (which is as near a full proof indicator of recession as we have) suggests by year end we will have a recession. Of course the Fed could halt its likely June, September, and December rate hikes (I'm assuming 30bps each...though 50bp jumps aren't out of the question) and/or the 10yr yield could rise (but below I'll show why this is highly unlikely). So, absent course correction, the spread on bank lending will vanish and likely turn negative by year end...and the economic impact is a recession.
The spread is simply the difference of what banks borrow short, lend long, and live on the spread between the two. The upper and lower bounds of this spread are essentially represented in the chart below by the 10yr US Treasury and the FFR (the Fed influenced overnight lending rate between the largest institutions on reserves held at the Federal Reserve). Again, borrow short on a daily basis at near zero and lend long at near the 10yr yield.
The chart below is the spread between these two rates. Note, when the spread is minimal or negative, recession is either underway or imminent. Pretty much clockwork.
From 1950 to 1981, the Federal Reserve was intent on raising rates via the FFR, but to do so it had to raise the short term FFR significantly higher than the 10yr to successfully raise longer rates. The impact of successfully pushing longer term rates higher were rate inversion and recessions.
From 1981 to present, the Federal Reserve has undertaken five rate cycles, cutting rates but subsequently only partially hiking them back up. Each cycle cut rates deeper, held them at the cycle minimums longer, and subsequently hiked them less than before. But really noteworthy is that each time the US economy went into recession before the Federal Reserve could effectively push the 10yr yield higher via its short term FFR. Or more simply put, the Fed's tool to hike long term rates killed the interest rate sensitive economy before a long term rate increase could be achieved.
If we take the current rate cycle (below), we can see that since the Fed began hiking the FFR (now by 80 basis points), the 10yr yield is unchanged (2.3% when the Fed began and as of now, sitting at 2.24%). The Fed is messaging we should expect another three rate hikes this year (June, Sept, and December...assuming 30bps each). This puts the FFR at 1.8% by December and that is where I estimate the 10yr yield to be sitting by that time.
And finally, just focusing on the FFR minus 10yr Treasury spread in this current cycle. The chart below calls out the mileposts of rate cuts, QEs, the euphoric Trump bump, and now reality setting in (the green line represents 10yr interest rates remaining at current but FFR rising...the red line represents 10yr falling to 1.8% and meeting FFR at 1.8%). As the spread nears or passes through the 0% threshold, a recession is imminent.
If the Federal Reserve follows the path it is communicating, if the 10yr performs as it has for the last 4 decades, and the inverted spread indicates what it has for the last 7 decades, we will be in a recession in 2018. Why the Fed is undertaking this course is beyond me (I take my best guess HERE), but that's all you get from a middle aged, corporate washout, non-economist. I'm sure a highly paid shill will explain why it all makes sense and there is no reason for concern.
Extra Credit - The chart below shows FFR vs. the inverted 10yr minus FFR spread from 1990 to present. Once rate cuts were exhausted and could no longer be used to drive the spread, QE was used to goose the spread. Rate hikes (balance sheet reduction?), collapsing spreads, and a resultant US recession are up to the Fed.