The Fed Between Scylla And Charybdis: An Update
About three years ago, I wrote that in raising rates the Fed was caught between the Scylla of higher long rates killing the housing market and the Charybdis of falling long rates causing a yield curve inversion, and that "The Fed has to hope that long rates remain in a narrow band of stability."
So far, long rates have remained within the safe zone. Let's take a closer look.
Let's start with the 10-year treasury yield (blue) vs. the 2-year yield (red):
As you can see, on a historical basis these aren't particularly tight, as the difference between the two in yields was in this area through most of the 1990s and the 2000s expansion as well. It is only on the basis of this expansion that the difference is tight.
Further, the 10-year has - so far at least - not breached its 2013 high of 3.04%. In fact, the danger that long bond yields might breach the 3% level appears to have been a driving force in the stock market selloff at the end of January.
But while long bond yields staying below 3% is a good thing, e.g. for the mortgage rates and the housing market, the yield curve is tightening up.
Below are two comparison graphs from StockCharts.com. In each, the yield curve as of last week is bookmarked in darker red. The lighter red line shows the two points during the last expansion when the overall curve - especially the middle part of the curve - had a similar slope, in July (left) and November (right) of 2005:
For a longer-term look at the middle part of the yield curve, the below graphs show the 10- minus 7-year treasury yield difference (blue) and the 7- minus 5-year treasury yield difference (red):
On a long-term basis, these aren't quite at the low levels that would cause concern. On the other hand, when we zoom in on the last year...
... we see that the 10- minus 7-year difference is down to only about 0.05%.
One difference between now and in 2005 is that then the Fed was in the midst of aggressively hiking rates by 4.25% in a little over two years, versus 1.50% in the last three years.
On the other hand, if the past several years are a guide, it will probably only take two more rate hikes - and perhaps only one more in the case of the 10- minus 7-year difference - to cause this middle portion of the yield curve to invert.
Ironically, while there seems to be built in resistance to the long bond going over 3%, an inversion could easily bring about a flight to safety, which would only cause a further inversion.
It is getting ever harder for the Fed to steer between Scylla and Charybdis.
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