The Fed is about to raise rates Wednesday. The yield curve will flatten even more in the next few days if the Fed stays consistent with its plan to raise rates 3 times this year. The current difference between the 2-year bond yield and the 10-year bond yield is 85 basis points. I have said a 10% correction in the S&P 500 is possible if it falls below 75 basis points. The chart below shows the process of the yield curve flattening as the Fed raises rates. According to Citi Research and Bloomberg, we’re almost 30% through the Fed tightening cycle. There’s still about 100 basis points more for the yield curve to flatten and then invert if the cycle matches the average.
I don’t see this tightening cycle playing out anything like the prior few, so the chart above might be worthless for forecasting the direction of the yield curve. The chart below supports my claim as it shows the advanced 6 quarters real GDP growth falling. The core CPI will probably fall along with the real GDP growth as it has already been falling for a few months and because it has been highly correlated with real GDP growth historically. If GDP growth and CPI fall in the 2nd half of the year, the Fed might rethink its 3rdhike and will definitely pause further rate hikes in early 2018. Each chart I show which shows disinflation furthers the evidence that the Fed won’t be able to ignore this. The best way to ignore a trend is to show an indicator which isn’t consistent with the others, but if they all show the same trend, it’s impossible to ignore. The mere mention that disinflation is a real trend will cause the market to see the Fed as being dovish.
In terms of the yield curve, the Fed pausing rate hikes would steepen it on the short end. The weak economic data would flatten it on the long end. The result of this would depend on how dovish the Fed becomes and how bad the economic data is. This is all speculation as I lean towards the idea of the Fed becoming more dovish in its next meeting. If the Fed is hawkish, the yield curve can easily invert by the end of the year if the economic data disappoints.
