Meanwhile in the real world, people like Rudiger Dornbusch observed that most economic fluctuations were simply driven by aggregate demand shocks. Furthermore, money and credit seems to play a crucial role, a factor that is often forgotten and omitted, at least in the more simplistic DSGE models that are nowadays used by modern macroeconomists.
But I digress. More often than not, the Federal Reserve tends to kill the Business Cycle by engaging in a premature and/or excessive tightening cycle, thus hiking interest rates by more than what is warranted by underlying economic conditions.
One of the very few leading indicators of a coming recession is the structure of the yield curve, i.e. the relationship between short-term and long-term interest rates with respect to each other. Economic theory suggests that long-term interest rates are simply the sum of all future expected short-term interest rates. Consequently, the two-year yield of a bond is simply the yield of a one-year bond plus the the yield of a one-year bond purchased one year from now.
However, investors also must be compensated for maturity risk. Since the risk of holding a long-term bond is higher than holding a short-term bond, interest rates on longer-dating securities are usually higher. Consequently, the yield curve is mostly upward-sloping. A flat yield curve or even an inverted yield curve where long-term interest rates are lower than short-term interest rates, on the other hand, usually spells trouble ahead. The picture below shows the difference between the two-year Treasury Securities and 10-year Treasury Securities.
We now have reached a point again where the difference in yields between longer-term securities and shorter term securities has narrowed a lot over the last year
(see the picture below for how the yield curve has evolved from December 2016).
While many other banks apparently expect long-term interest rates to rise in the near future as global growth and also U.S. growth has picked up some steam over the last year, JP Morgan apparently expects the yield curve to flatten even further, potentially becoming flat or even reverting by the end of next year.
This, in my opinion, really is not such an outrageous prediction to make. The Fed really seems to be hell-bent on its tightening cycle despite falling short of its inflation mandate of 2%. Tomorrow, they will increase short-term interest rates by another 25 basis points, which will lead to further flattening of the yield curve.
While we are not quite there yet, the yield curve is very likely to become flat or even revert if they will hike by another 3 to 4 times, which they currently project, a forecast that is overly optimistic in my opinion.
Note that over the last 3 years the tightening cycle has turned out to progress much more slowly every single year than projected by their forecasts. That is because economic conditions simply do not warrant much higher interest rates at this time.
With Yellen being replaced by Powell as new chairman, we do not exactly know how the Fed will behave in the coming years. At the moment, the U.S. economy is approaching full employment and GDP growth is slightly above potential. So right now there is little to worry about. However, we know that an excessive tightening cycle can surely engineer a recession. So it is time to worry if the Fed will continue to hike next year with long-term yields barely budging because that would imply an inversion of the yield curve and thus bad news. This time is now different despite some claims to the contrary.