It’s early for that bugaboo, but it is mercifully obscured by another one: “yield curve inversion.”

First the data, then define the terms, study the patterns, and make a wild guess.

Monthly orders for “durable goods” are a valid signal for business conditions, and the word from May was surprising: volatile orders for transportation aside (airplanes), the rest were to have grown by 0.5% in the month and instead fell 0.3%. This category is supposed to benefit from the new tax cuts and federal spending.

Today also from May, personal income rose 0.4% but spending only 0.2%. “Personal Consumption Expenditures,” the technical version of consumer spending has dropped from annualized 4%-ish to 3%-ish. The stagflation aspect: for the first time since 2012 the “core PCE deflator” (the Fed’s favorite measure of inflation) has risen to 2.0% year-over-year and is accelerating, Jan-Feb at 1.5%, Mar-Apr 1.8%. “Real” personal income is nominal minus inflation, and it is steadily falling, prior months revised downward.

Stagflation is very rare — a stagnating economy is incompatible with rising inflation. For inflation to rise we must have rising incomes to pull prices up. Or, as in the 1970s a catastrophic increase in the cost of a key commodity — oil leaping from $3.00/bbl to $35/bbl in just eight years, 1972-1980.

One other way to produce inflation while incomes are flat, this one of immediate concern to the Fed: the Fed and Congress shoving money into the economy to get higher growth and instead just getting higher prices.

How can this be? Look outward: global competition has capped many categories of US wages no matter what the Fed and Congress do to boost growth. Pushing on the proverbial string.

Oil has risen $15/bbl in nine months to $74/bbl, but energy is excluded from “core” inflation, and the Fed tends to see small-scale energy spikes and ramps as transients not affecting the deep structure of prices. Rising oil also tends to hurt consumers.

Taking all of that in, if you’re the Fed you feel confirmed in gradual rate hikes: inflation is the enemy, and unsustainable growth must slow.

Now shift signals! To this inversion business. That term, together with “flattening yield curve” refers to a closing spread between long-term yields and short-term ones, which when reaching upside-down conclusion has accurately predicted recessions. All of them.

For civilians: long-term rates should always be higher than short-term ones because risks expand with time. The mechanism for short rates to rise above long: a central bank hiking short-term rates until the economy cracks.

The long-short spread this week reached its narrowest since the last recession, the 2-year T-note at 2.52% and the 10-year at 2.84% — just 32 basis points apart. When the Fed hikes two more times and if long-term rates stay put as they have since February, we’ll be inverted. Will that mean recession soon?

The Fed yesterday posted a short internal paper titled “(Don’t Fear) The Yield Curve.” With a title like that, prudence would be to sell everything and move far away. This time I think the conclusion may be correct, but the method in the paper is the very worst of the Fed. Quantism. On Wall Street a “quant” is a well-educated genius engaged in “quantitative analysis” to find mathematic convergences. These correlations do work in trading until they end in seismic error (see Long Term Capital Management 1998, whose warnings we ignored and gave us 2008). An except from the “(Don’t Fear)” paper:

The forward rate at a given maturity can be thought of as a gauge of the market’s expected short rate at that horizon, plus a term premium. On the other hand, because a bond’s yield is an average of the forward rates over the term of a bond, yields tend to dull the signal embedded in forward rates. The near-term forward spread we focus on is the difference between the current implied forward rate (on Treasury bills) six quarters from now and the current yield on a three-month Treasury bill….

Oy. Instead of quantism, stick with plain sight. The Fed begins to hike the cost of money when the economy grows beyond capacity, and intensifies the hikes at signs of overheating. When the Fed makes the turn from stimulus to tightening, long-term rates jump faster than the Fed out of fear for how high the Fed may go. Then the two rise together until another magic moment: the Fed keeps going up, but long-term rates stop. Inversion end-game.

Do long rates stop rising, as now, in anticipation of recession? Most bond traders and salesmen would argue otherwise: as the Fed pushes up the whole rate structure, long-term yields become irresistible to buyers. The buyers are predicting the past: they see deals better than any in the prior several years — just as now, a 3.00%-paying 10-year last available seven years ago.

Meanwhile the Fed continues to hike because it takes time for hikes to slow the economy. The Fed always overshoots, with the best of intentions but slightly panicky about inflation. The most powerful hike-to-effect lag: housing feels rate hikes first, but the labor market — central to inflation-fighting — takes a year or two to roll over. Hence repeated massacres of housing. (Note: on the far side of the recession as rates fall, housing recovers quickly but jobs don’t, so the Fed overdoes its backside easing.)

Today’s stalled long-term rates and incipient inversion are a false signal, and complicate the Fed’s life. Long rates are clearly pulled down by global ones, German 10s today 0.304%, Japan’s 0.032%. The bond market response to Fed hikes is all screwed up: the Fed has hiked 1.75% since December 2015, and the 10-year T-note since then has risen only one-third as much, from 2.30% to roughly 2.90%. Mortgages are up from the 3.50% all-time lows, but the pre-hike centerline was closer to 4.00%, and today’s 4.75% is not slowing anything.

The Fed always has trouble, but this predicament is new: long rates staying down are canceling the effect of hikes in short-term rates, not at all a traditional flat-curve warning to the Fed that it is going too far. The Fed does need to slow the US economy back to 2% GDP or so, but if long rates stay down then short rates have a long way to go up. No market is prepared for that possibility, quickly becoming probable.


US 10-year T-note, stuck since February:


The Fed-predictive 2-year T-note has stalled for two months, most likely a mis-pricing which may also have overseas roots:


The newest economic data has ker-plunked the Atlanta forecast, but from sky-high to sensible:


The ECRI is always less hysterical than other measures, and has the economy in remarkably steady growth above the fed’s target and oblivious to the Fed’s hikes:



Markets held tight ranges this week, the 10-year T-note entering its sixth month trading between 2.90% and 3.00%, lowest-fee mortgages roughly 4.75% throughout.

The week brought little new economic data, and efforts to think about anything were discombobulated by political eruptions. The most important economic aspect, the onset of tariff war was still tops on the addled minds in markets.

One bright moment of clarity came in a speech by Chair Powell on Wednesday. Instead of reading the predigested propaganda of Wall Street and its economist sales-assistants, go to the source. Powell is not an economist and writes in English. He was educated by Jesuits, who insist on good thinking.

Powell’s speech is short. The opening sentence: “…The U.S. economy is performing very well.” The last sentence of the introduction: “…the case for continued gradual increases in the federal funds rate is strong.”

If you find ambiguity there, please let me know. Markets disbelieved the Fed’s warnings of rate hikes to come from 2012 forward and were right. Now their skepticism is misplaced.

The body of his speech is a concise (two page) discourse on the inexact science of central-banking, and a fine historical review concluding with “The lack of useful historical precedent leaves us with some uncertainty….” Yellen agreed.

Powell concluded that there are no early signs of inflation despite extraordinarily low unemployment, but our risks are not limited to inflation. “We have often seen confidence become overconfidence and lead to excessive borrowing and risk-taking, leaving the financial system more vulnerable. Indeed, the two most recent U.S. recessions stemmed principally from financial imbalances, not high inflation. While some asset prices are high by historical standards, I do not see broad signs of excessive borrowing or leverage.”

We do not have current inflation or exuberance problems, therefore we are undertaking prudent pre-emption because the economy and employment are so strong.

How much pre-emption is prudent? Back to Powell’s first paragraph: “Growth is meaningfully above most estimates of its long-term trend — though admittedly, that trend is not as strong as we would like it to be.” The first half of that sentence is for us in markets, the second half to keep idiot politicians off his back, those who think the economy can grow to the sky without risk, and the Fed is the problem.

The longer we grow above trend, the riskier growth becomes. If the economy begins to show signs of inflation or imbalances, the Fed will lean hard and recession would follow. Instead the Fed would love it if we would slow down gently and soon for any reason — rate hikes, tariffs, or no reason. The new tax cuts and spending reduce the likelihood of spontaneous slowdown, and so the Fed is forced into this gradual pre-emption, hoping to detect a slowdown and stop hiking before over-doing. What are the Fed’s chances?

Ha. Aha-ha.

Fortunately, in today‘s world, the chances of premature recession are higher than the chances of letting inflation out of the box. You kids under 60 do not want to live through a time of Fed catch-up. I’ll take a too-quick recession every time.

A brief history of Fed time follows, which Powell shows that he is studying carefully.

Modern economies and central banking began at the end of WW II in 1945. Since then two big changes have altered the Fed’s operations.

Prior to 1978 the Fed’s Regulation Q capped the interest rates which banks paid to depositors. Creating a recession was simple: sell short-term Treasurys, forcing up yields until they exceeded the Reg Q cap, and deposits then flooded out of banks into Treasurys. No money to lend, old loans had to be called — a “credit crunch” and recession. Let the recession run long enough to extinguish inflation, then back to normal.

By 1978 Reg Q had to go. Electron thingys had infected money, which began to flow around regulations of all kinds. So, in 1979 when Paul Volcker had to stop inflation running at one percent per month he had no choice but to run interest rates to the moon until the economy cracked. 18% mortgages and 22% “prime” — both nearly double the rate of inflation to get inflation to come down.

The second big change since 1945: the 1990 end to the Cold War and the opening of China and eastern Europe. Nobody saw it at the time, but the natural tendency of economies to overheat into inflation gave way by globalization to wage and price suppression and a natural tendency toward deflation.

Powell’s speech included a look-back to the last time US unemployment was as low as now, and the onset of inflation — in the 1960s, and not comparable to today. US labor markets had no overseas competition. Japan exported transistor radios, not yet autos; wide swaths of Europe had just come off war-rationing of food. An overheated US labor market quickly went to wage-price spiral.

Our recessions since 1990 changed prior pattern. The one in 1990 was partly old-fashioned: after the Crash of ’87 new Chair Greenspan took Fed funds back up to 10% (mortgages 12%), inflation then 5%. Yup, recession — although the Fed was surprised, and had to ease all the way to 3% in 1993 to get us out of it.

Then from 1994 to 2000 the economy ran hot but inflation did not, and we entered a phase of self-congratulation. And an IT bubble. Inflation rose from 2.5% to 4%, the Fed went to 6.5% and… both bubble and inflation crashed. Note how little above inflation the Fed had to go to get a recession result. (Further note: falling inflation and rates create asset bubbles; as the rate of discount falls, present value jumps.)

Next, in a period of idiocy having nothing to do with Fed monetary policy, instead the greatest financial crime of all time, Wall Street intentionally manufactured and sold several trillion dollars of IOUs guaranteed to default. “Financial imbalance.” The Fed’s brief maximum rate in the period was 5.25% versus inflation about 3.5%. Then as all good kids know, the Fed had to go to zero for seven years.

Globalization and wage and price suppression live on today. The last three times the Fed lifted its rate significantly above inflation (“imbalances” be damned) we had surprise recession and a surprisingly deep one. The Fed’s rate is now at the rate of inflation. How far up before — in the magical prescience of a fortune-teller — the Fed accurately anticipates a slowdown ahead and stops?


Chart is from 1983 to present, core CPI inflation in blue, Fed funds in red. Prior to 1990 the Fed had to hike far above inflation to stop it, and into the mid-‘90s above inflation just to keep it under control, but less and less. Since 1990 accidental overdoing has been the rule:


Long-term US interest rates today are the same as one week ago. How we have arrived at unchanged is a good yarn.

The eventful last week began with the G-7 meeting and our declaration of war on Canada. Prime Minister Trudeau got his “special place in hell” by objecting to US tariffs imposed by Trump using Cold War national security powers. Puzzled and annoyed (politely) Canadians had not known that they are a security threat.

Then the Trump-Kim summit. The consensus among analysts seems to be, “Um… What was that?” Mr. Trump’s performance in Singapore recalls James Thurber’s essay, “If Grant Had Been Drinking At Appomattox,” in which a confused Grant offers his sword to an equally confused Lee. Trump does not drink, but fractured thinking does not require alcohol.

Markets ignored both of those adventures, instead focusing entirely on central bank meetings, the Fed and ECB on Wednesday, the BoJ on Thursday. More on them in a bit — yesterday Trump topped the central bankers in one swell foop, proceeding with a tariff on China’s exports. That did it. Trade war has caved-in the stock market’s knees, which has helped interest rates to stay put. China will retaliate, but we might get lucky, noise and tit-for-tat posturing but then stopping. However, the same thing lies ahead with Europe, and canceling Nafta would open hostilities with both Canada and Mexico, our two most important trading partners. At the moment a threat, not yet an event.

Before discussing the Fed (save the best for last), first the two lesser central banks. In grand European style, the ECB announced that it will stop buying IOUs in December, but will hold the cost of money to negative-0.4% “at least through the summer of 2019.” Thus simultaneously ending stimulus and continuing stimulus, the yield on German 10s fell to 0.40%, also pulling down on US rates.

(Euro footnote. At a time when the zone could provide some much-needed global leadership it is slipping back into local dithering. Merkel’s government and career may fall any day. The US has its immigration issues, but at least makes its own decisions. Germany via Brussels insists on making immigration decisions for the others, and its own absorption of one million refugees last year is not going well.)
The Bank of Japan today said that it would “patiently continue current monetary easing.” Yup, forever. Japan’s GDP today is about the same as 20 years ago, now about one-quarter the US. Its budget deficit is 4.5% of GDP, about $225 billion. The BoJ today re-committed to buying government bonds at an annual rate of $725 billion (not a typo, three times the issuance of new IOUs). Its 10-year bond yield is 0.036%. Japan’s continuing existence as a financial entity is imaginary, but will last as long as its citizens believe in the yen.

The Fed.

Two huge changes at the Fed are underway, masked by this week’s net-unchanged markets and goofy public policy.

First, from now on the Fed’s rate hikes will matter. Two-and-a-half years of quarter-point nibbling at the cost of money, from 0.25% to 2.00% had no cost or risk, just going from nothing to something. Now “prime” is 5.00%. Helocs will adjust to 5.00% or more this month, as will adjustable-rate mortgages. Every new hike will bite into borrowers.

Second, if the economy does not slow of its own accord the Fed will force it to slow. Chair Powell’s post-meeting written statement and press conference were things of beauty, pleasant shifts from academic-wordy to cordial but blunt and narrow. He dodged every opportunity to engage in politics (trade issues, for example), and gave markets less information about future policy. That tell-‘em-nuthin is back to the future: the old-fashioned Fed always wanted markets to trade on economic information, not Fed wig-wags.

Powell’s two velvet sledgehammers: first in his post-meeting statement, de-bloated by one-third, he removed this line: “… The federal funds rate is likely to remain, for some time, below levels that are expected to prevail in the longer run.” We’re not saying when we’re going higher because we don’t know, but mark your calendars for June 13, 2018 for the day the Fed flipped from stimulus to leaning against the economy. Powell’s second signal: “The US economy is in great shape.” The Fed’s job in that case: to take away the punch bowl. He did not use McChesney Martin’s old saw, but might as well have had a punchbowl as a prop.

These Fed changes are unmistakable to markets. So, why are rates unchanged? Short term rates rose a bit, the 2-year T-note to 2.56% rising mechanically in anticipation of another Fed hike in September. However, the credit markets are not priced for the Fed’s advertised even-money bet for another hike in December, and three or four more in 2019.

Why? The credit markets spent the last ten years disbelieving the Fed’s announced intentions to hike. It may take a while to react fully, which makes the Fed’s job harder. If we hike and you don’t take us seriously, then we have to hike harder. (Smiley emoji.)

Second, markets feel protected by the possibility of an “inversion,” short-term rates rising above long ones. The Treasury 2s-to-10s spread this week contracted to its narrowest in this cycle, only 36bps. Everyone knows that an inversion means a recession ahead, and the Fed would not invert us on purpose… would it?

Hell yes, it would. Especially if long-term rates are artificially suppressed by global buying of US long-term bonds. The ECB and BoJ own all the good-quality ones. Our 10s pay 2.91%. Or you could buy an Italian one paying 2.60%. Or a UK “gilt” for 1.33%. A Spanish 10 gets you 1.29%. France pays 0.73%.

The Fed must switch to a pre-emptive stance even if inflation does not rise much above 2%. That is its job. An inversion is no protection, merely an international curiosity which can force the Fed to hike short rates faster and farther. For our own good.


The 10-year T-note just in this last week. What was more important, the Fed on Wednesday, or tariffs on Thursday? You be the judge:


The 10-year T-note in the last year, stuck since February, outside pressure canceling the Fed:


The Fed’s infamous “damned little dots,” each official casting a marker for the location of Fed funds at the end of each year. Throw out the top four and bottom two (the Fed coop includes four known hawks and two doves, and we don’t call ‘em bird-brains for nothing). The other voters mean business — their 2019-2020 estimates are above the “longer run.” Bye-bye punchbowl:


One economic indicator has shifted to heat. The NFIB small-business survey from the 2016 election forward was more political pleasure than actual business performance, optimism way out-running results. The survey for May shows fundamentals quickly catching up:


This past week has been quiet in anticipation of the five-ring circus in the week ahead.

The program: G7 meetings underway now and through the weekend, the Kim summit and European Central Bank (ECB) on Tuesday, the Fed on Wednesday, and the Bank of Japan (BOJ) on Thursday. Each event can have significant economic effect, including immediate changes in interest rates.

Before handicapping the relative impact of each pending performance, a surprise! A retired lion-tamer has just entered the center ring! Although this time accompanied by an odd-looking dog….

Ben Bernanke yesterday: the new tax cuts and federal spending “make the Fed’s job more difficult all around… stimulus at the very wrong moment is going to hit the economy already at full employment in a big way, and then in 2020 Wile E. Coyote is going to go off the cliff.”

Bernanke is not given to intemperate remarks, and may modify these in days ahead. However, as a forecaster he is hard to argue with. Just this: we can hope that the tax bill was so badly crafted that it does not stimulate, just lines the pockets of the lucky.

The circus rings in chronological order, beginning with the G7… the G7 are Canada, Italy, France, Germany, UK, Japan, and the US. As a group, the “West,” the legacy winners and losers of World War II who took the vow never to do it again, and the center of global economic cooperation. It used to be G8, but Russia was expelled after invading Ukraine.

Among the leadership of the G7 and their peoples, Mr. Trump is by a wide margin the most-disliked US president ever. Emanuel Macron of France yesterday tweeted in English: "The American president may not mind being isolated, but neither do we mind signing a six-country agreement. Because these six countries represent values, they represent an economic market which has the weight of history. No leader is eternal. We inherit commitments which are beyond us. We take them on. That is the life of nations."

Departing for the meeting, Trump wished for re-inclusion of Russia. Nebraska Republican Senator Ben Sasse today: “Putin is not our friend and he is not the President’s buddy. He is a thug using Soviet-style aggression to wage a shadow war against America, and our leaders should act like it.”

Ouch. The direct cause of economic unpleasantness in the 1930s was the breakdown of international cooperation. G7 discord if it grows and includes China would be an economic suppressant, including pushing down interest rates although at a cost not worth paying.

The ECB on Tuesday… the ECB is still buying 30-billion euros-worth of IOUs every month, and maintaining a cost of money at negative point-four percent. Claims of healthy European growth ring hollow in light of that on-going stimulus and core inflation barely above 1%.

ECB effects are likely to be perverse. If it begins to stop its IOU-buying, in theory interest rates would run up in a colère du temper; however, past ECB suggestions of tapering have brought the opposite. Withdrawing stimulus invites a weaker economy and lower rates. Also, the ECB will soon change leadership from Mario Draghi and his “whatever-it-takes” to a new president. Since ECB founding in 1998 the Europeans have not allowed a German president (so far, Dutch, French, and Italian), and the Germans are becoming insistent. A German ECB president may not be as reluctant as the others to have a recession named after him.

Also on Tuesday, the Kim summit. Oddsmakers assume a non-event. Posturing without real progress, although retreating some distance from the imminent threat of military action. Given the volatility of the parties, no telling. If it does not go well, fear in markets pushes money to US bonds and rates go down.

The big show is Wednesday, the Fed. It will increase the overnight cost of money from 1.75% to 2.00%, taking “prime” to 5.00% for the first time since 2008. The big question for housing: will long-term rates also rise .25%, putting mortgages astride 5.00%?

The answer will depend in part on what the Fed says. The Fed’s neutral rate — neither tight nor easy — is defined as the rate of inflation, now presumably 2.00% plus some body-English and Kentucky-windage which varies from time to time (a lot), today perhaps another half-percent. The heart-stopping moment, gasps from the crowd will be when Chair Powell sticks his head into the lion’s mouth. He will volunteer or certainly be asked, how close are you to “done?” Will you stop at neutral, wait for possible inflation data? Or ooch your way on past neutral?

I suspect that Powell will struggle to get away with “too soon to tell,” and further suspect that the Fed may be past neutral on the tight side now at 2.00%. Evidence: the Fed has pushed 10s up, not inflation. Evidence II: despite Bernanke’s sense of stimulus, if it were truly hyper-goosing the economy we would see it by now.

The 10-year T-note has been within an inch of 2.90% since January, mortgages similarly close to 4.75%. In the last two months the 10-year spread to the 2-year Treasury has been locked at .45%. If the Fed is already on the tight side, 10s will rise only a little above 3.00%, mortgages still below 5.00%, and the 2s-10s spread will close — all indications that the Fed will pause after another hike or two.

If the spread does not close, 10s and mortgages rising with Fed funds, that will suggest the Fed is on a necessary pre-emptive course intending to skim the froth off the economy.

Oh — the BOJ on Thursday. By then the crowd will have left. Nobody around but the custodians sweeping up after the elephants. The BOJ has lost its freedom of action (a caution to all), Japan so deeply in debt to itself that the BOJ in perpetuity will attempt to hide it from sight.


US 10-year T-note in the last year:


Fed-predictive 2-year T-note:


The Atlanta Fed GDP Tracker is smoking in Q2, but in large part a natural rebound from weak consumer spending in the first quarter:


All of these forces in play: the Kim summit, Italy, Fed, tariffs, inflation, economy, jobs, and the president — which are drivers, and which are noise?

This week markets told us. And when the Fed finishes its meeting on June 13, markets will tell us a lot more.

The two biggest financial markets are stocks and bonds. Ownership in corporations, and IOUs. The stock market is an emotional place, false signals more common than not, and not a character flaw: future earnings cannot be known. Bonds… we may not know anything else, but we know the interest rate and maturity stamped on the damned things.

The stock market’s two-month peak was on May 21, just as adventures in public policy began to rattle all markets. In Dow terms today, the market is 350 points below that top — small, but breaking the tentative recovery after the big drops during winter.

The 10-year Treasury yield peaked on May 17 at 3.11%, mortgages at the threshold of 5.00%, anticipating a strong economy and open-ended Fed hikes. By this past Tuesday 10s fell to 2.76% intra-day (35bps is a lot), mortgages nearly 4.50%. Long-term rates have rebounded a little, 10s 2.89% today and mortgages just below 4.75%.

Long-term rates are controlled (mostly) by inflation; short-term rates are set by the Fed, the 2-year T-note the benchmark. 2s topped on May 16 at 2.59%. The Fed’s overnight cost of money is 1.75%, thus 2s anticipating additional hikes. On this past panicked Tuesday, 2s intra-day fell to 2.30%, now back to 2.47%.

Most important: none of these markets is back to where it was before the multi-source panic in the last 10 days. Something(s) is still worrisome, but what?

Italy has a new government as of yesterday, no more stable than its other 60-odd governments since Mussolini but imminent financial/political collapse is off the table. Inevitable, but back to any-decade.

German 10-year bonds peaked on May 15 at 0.648%, the highest yield in three years reflecting a better European economy and anticipating the ECB gradually shutting down its money hose. In Tuesday’s panic German 10s fell to 0.255%, and today have rebounded only to 0.388%.

Right there is the key clue: Italy is off, so what is still troublesome to Europe, sustaining panicked buying of German bonds?

Tariffs and tariffs. Same in the US. The Kim summit if it happens will be a photo opp, or maybe the first in a long process, or if it does not happen just back to status quo.

The May employment report was strong, double the job growth which the Fed thinks is sustainable, and all of the evidence and cover the Fed needs to continue upward.

The president is wearing out everyone in markets, even those who like many of his policies. This morning’s tweet three hours in advance of the job-data release, “Looking forward to seeing the employment numbers at 8:30 this morning”, was disgusting to traders of any political bent. Of course his standard cutesy-ambiguous style, but everyone knew what it meant and traded on it. Every trading desk studies the release of new data, knows exactly who has the data before public release, and is on constant alert for the slightest leak ahead. At the Fed, the Department of Commerce, the Bureau of Labor Statistics… at every data-generating agency or private source, a leak is demoralizing. A shoulder-sagging, head-down devaluation of the work that they do, and traders apoplectic.

Tariffs and the Fed. The Fed will hike again on June 13, stick with “data dependent” to describe future action, but will not stop at 2.00% or 2.50% so long as job growth continues as now. The only explanation for suppressed markets since Tuesday, not fully rebounding: tariffs. The extent of trade war cannot be known, but even if modest there is also growing collateral damage. We are head-slapping our allies — what happens when we need a friend? What is the point of making any deal with the United States if it feels free to demand unilateral renegotiation at any time? The president loves to wield this power, but the world is not the same as New Jersey and small-time deal guys out-crooking each other.

The most immediate tariff effect is not likely to be full-go trade war, just small reprisals, audible teeth-grinding, and a quiet but unprecedented overseas hatred directed at us. If we cancel Nafta, then the international fabric of trade rules and manners goes also.

The Fed. Technical, eye-glazing, but the big, big deal for mortgages: what happens to the 2s-10s spread after the Fed hikes again? Last fall the 2-year Treasury was 1.40%, and 10s 2.40%, the spread one whole percentage point. Since then 2s have been pushed up by the Fed faster than 10s have risen in anticipation of a hotter economy (fiscal stimulus), inflation risk, and the Fed.

In April the 2s-10s spread closed inside one-half percent, and since then has held a mechanical, lurching Frankenstein spread centered on 0.45%. All through the tops in May and panic in the last week, bolted together.

On the 13th the Fed will go from 1.75% to 2.00%. 2s-10s follow, mortgages will reach 5.00% and we’ll wonder again, how high before housing cracks.

If 10s do not follow, that’s the warning to the Fed that it’s closer to being done than it may think, and further hikes risk recession.


Us 10-year T-note. As panics go, a pretty good one, but 2.90% held:


The US 2-year T-note. I think the 2s-10s spread will tighten on the 13th:


The administration and supporters will be thrilled by second-quarter GDP north of 4%, but it’s just a rebound in weak consumer spending in the first quarter and will likely back off to 2%-something in the rest of the year:


The ECRI’s long-term perspective is the best, and has us right in the sweet spot of modest, non-inflationary growth:


On the Friday before Memorial Day markets close early, and the whole week is usually a snoozer, Wall Street big shots already headed for the Hamptons to kick sand on weaklings.

Surprise! And not just one… too many to count.

In the biggest effect of all of the surprises, long-term rates have come down — a classic reversal of “everybody knows.” Everyone has known that long-term rates are going up. Not this week: the 10-year T-note fell to 2.93% today, down from the spike to 3.11% just seven trading days ago, and puling mortgages near 4.75% or lower.

Maybe a whole bunch of money decided to play it safe, buying bonds before a long weekend, a temporary thing. But several surprises have acted in concert.

Tops, today: the Saudis and even Russia are suddenly loosening the hose-clamp which had taken oil to the mid-$70 range, headed for $80-plus. An oil cap would limit the inflation risk which oil had added to the previous rise in long-term rates. Why would the Saudis and Russians ease up? So that prices do not spike and encourage new supply and conservation. Every drug-pusher knows that.

Right behind that surprise… European structural weakness is back in play. Its best overall economic indicator in May ker-plunked to the worst result in 18 months. Italy is again behaving like Italy. Brussels is behaving miserably to Brexit, making it as hard as possible as a warning to any others tempted to escape — this week interfering in resolving the border between Ireland and the UK North. In a heavy German accent.

An essential global indicator is the yield on German bonds. Back in 2016, the ECB madly buying IOUs, German 10s were stuck below 0.20%. Since then, in the warm glow of pretended European recovery and potential ECB normalization (its overnight rate is still negative .4%), German 10s made it to 0.71% by February, dipped a little and back to 0.64% two weeks ago. Today, 0.40%. Plunging by one-third is big stuff, and pulled our 10s down, too. Some of the German drop is due to those new stresses in Italy, its 10s soaring to 2.54% — in the same currency, same central bank.

The Trump administration this week contributed its surprises. On Monday it threatened to impose tariffs on imported cars, in continuing misuse of Cold War national security authority granted to the president by Congress in 1962. Tariffs and taxes are the business of Congress, not presidential orders. Tariffs on cars is the worst trade-war idea yet. But, just to keep everyone guessing, we have let China win our trade war with them, and the president proposes a free pass for China’s thieving ZTE, bi-partisan objection in Congress.

The North Korea summit… our side thought we were meeting to accept their surrender. Get the Missouri out of mothballs, let Kim sign on the quarterdeck. If North Korea intends to pursue economic integration and health, and to pull away from nuclear confrontation, the internal consequences in the DPRK will require delicate work. After three generations of Kims, subordinate leadership will have to find other work, and its people adjust to a new world. Isolation does wild things to societies — google “DPRK juche” for a glimpse. East Germany was run by Soviets for half as long, and the East still struggles to re-integrate.

Then there is the Fed. Some say that US rates have dropped because the Fed is packed with doves and policy is too easy. Others say the Fed is too hawkish and rates are falling in anticipation of an economic slowdown or recession.


The Fed could not be more clear. Its forecasting tools have failed to work for a dozen years, which it knows. It is always “data dependent,” but when it uses that phrase today the Fed is saying that it’s reacting from one economic report to the next. All data say that the economy is healthy enough for the Fed to raise the cost of money to a normal level relative to inflation. From today’s 1.75% Fed funds to something 2.50%-3.00% by the end of 2019.

However, if your best foresight is tapping ahead with a white cane, better go slow. If you sense an edge, stop.

Next Friday we get employment data for May, more likely to be strong than weak. 2nd Quarter GDP is going to grow in the 3.5%-4.0% range. Tap, tap… no edge.

The Fed’s next meeting is June 13, and it will hike from 1.75% to 2.00%. The big question then: what happens to other, longer-term rates? In the last month, any time 2s have risen so that the spread to 10s has closed to 45bps, 10s have popped up. After the 13th, 2s up, 10s not so much, narrowing spread? A warning of Fed overdoing. Spread constant, tap-tap-tap on ahead.

The Fed plans a third hike this year, but we’ll get a tremendous amount of data between now and fall. The Fed could stay on track, accelerate, or stop altogether.

The odds of a continuation of this week’s drop in rates to lower levels? Very poor. 10s face tremendous resistance at 2.90%, and the drop this week feels as though caused by unusual and largely overseas events, not trend-change.


The 10-year in the last year. The sharp drop this week is plain, as is remarkable stability since February, “resistance” to lower:


The 2-year T-note is peculiar — the long upward march consistent with the Fed’s intentions, but the drop this week…? Maybe oil settling down. Maybe too many traders had expected a fourth hike this year, gave that up? Indicating a stop to the Fed’s normalization? No:


Too strong for the Fed to pause:


Only two financial markets moved this week: oil, Brent crude reaching $80/bbl, and long-term rates rising decisively, the 10-year T-note to 3.12% taking mortgages within an inch of 5.00%.

The two moves are not linked. Oil is up because an excess in storage has been drawn down, and the Saudi/Russia combine has one foot on the hose — not a true crisis of supply. The higher price will attract new supply and reduce demand, and the contribution to inflation will be minor, crowding out consumer spending on other things.

Bonds and mortgages are relaxed about oil because they are worried about something else. The Fed. 

(Political sidebar: last week this space included a list of the major issues which could have big effects on markets, good or poor, each impossible to handicap and hence freezing markets. Trade, Korea, Iran, the budget and borrowing. In the last week each one has gone from high heat to unresolved fizzle, leaving markets exhausted, confused, and just as wary.)

The Fed. Everyone who notices interest rates has heard of the possibility of an “inversion,” short-term rates driven by the Fed above long-term ones, a splendid predictor of recession ahead. However, the progression from a little rate-hiking to recession is anything but straight-line, and bonds gave us other, solid clues this week.

The 2-year Treasury note is the Fed telltale. The 10-year T-note is the driver behind mortgages, which have a half-life of roughly six years, even if 30-year loans because refis and home sales shorten actual maturity. And the 30-year T-bond is the ultimate indicator of future inflation. Movement among these three instruments relative to each other this week brought exceptional clarity.

Last week the spread between 2s and 10s narrowed to the smallest gap in this cycle, 44bps (in bond speak “basis points” are one-hundredth of one percent, written as “bps,” and spoken as beeps — hence 44bps). 2s had risen to 2.54% in anticipation of more Fed hikes (the Fed now 1.75%, going to at least 2.25% by year-end), while 10s were stuck at 2.98%.

Narrowing spread… inversion soon? Uh-uh. The Fed’s pressure from underneath suddenly on Tuesday pushed 10s to 3.12%, re-opening the spread to twos, unchanged at 2.55%, spread out to 57bps. From here, so we will continue: 2s rising with the Fed causing intermittent hops in 10s — until 2s finally do close on 10s, signaling the end. More on The End below.

Meanwhile, the 10s-to-30s spread tells a different story. Go back one year and 10s traded 2.25% while 30s were 2.90%. Today at week’s end, 10s are 3.07% and 30s are only 3.21%. In the last year the 10s-30s spread has narrowed from 82bps to only 14bps. Twenty years of additional risk, and my reward is 14 whole bps? That spread closure is emphatic testimony that inflation is not a risk, and rates are rising solely because of the Fed’s effort to pre-empt economic overheating and the potential for future inflation. 10s and 30s so close is the next-best indicator after 2s-10s inversion as a sign that the Fed is approaching The End.

Way back in the 1950s-1960s, the Fed spoke of these hiking cycles as “fine-tuning.” By the early 1970s, “fine-tuning” had failed so badly that it became a term of derision. Overconfidence exposed, from the 1970s forward we used “soft landing” as the hopeful objective for Fed tightening, despite Fed-induced crash after crash. The only period of soft landing on record: in 1994 the Fed hiked from 3.00% to 6.00%, in 1995 backed off to 5.50% and escaped recession for four more years despite very narrow (“flat curve”) 2s-10s-30s spreads.

The US economy 1994-1999 was most unusual, in the first stage of the IT explosion — productivity, wealth creation, and low inflation. Also the “peace dividend” at the end of the Cold War reducing military spending in the budget, and enlightened tax and spending policy which led to budget surpluses (!!). Nothing enlightened now.

Enter new Fed vocabulary: “terminal.” Ouch. Terminal could be the place to catch an airplane or train (my Okie forbears said, “depot”). Or various illnesses including The End. The new Fed usage intends “the end,” but not that end, just the end of rate hikes.

How close are we to the end? Well, that depends. One end would be the Fed achieving soft landing, job creation falling to a sustainable level (relative to labor force growth), maybe 80,000 per month, inflation stalling at or a little above 2%, GDP settling to 1.8% growth.

Given only one soft landing on record, odds favor a different end: with the best of intentions the Fed will hike onward until we discover that a recession began four months ago.

To the impertinent question, how close are we? Spreads say that the Fed is now past neutral on the tight side, leaning into growth — or will be for sure with the next two hikes to 2.25% baked into the 2018 cake.

We never know how much Fed leaning the US economy can take, or for how long, but the outside world is likely to fracture before the domestic economy. In a globalized world, the Fed tightens for all.


US 10-year T-note in the last year, now pushed up by the Fed, not inflation:


During a Fed hiking cycle the US 2-year T-note trades at a higher yield than the Fed’s overnight rate, anticipating future hikes. The Fed’s next hike could come at the June meeting, or not until the one at the end of July. Whichever, that next hike is built-in. Not the next, and next, and next, each of which will push up 10s and mortgages until… terminal.


With apologies for complexity, here is a combined chart of 2s-10s-30s from 1990 to present. The visual may help with the spread gibberish above. Or maybe not. The extended tight-spread 1990s soft-landing was very different from the short 2006 precursor of disaster.