Don’t Fear the Inverted Yield Curve—Yet

Text transcript

Avery Shenfield, Chief Economist at CIBC.

We were quite concerned late last summer that the central banks in both Canada and the U.S. were on a path that would risk an overkill in terms of the pace and destination of interest rate hikes. But of late, both central banks now seem to be recognizing the reality of this cycle, which is that neither the U.S. nor the Canadian economy is showing enough momentum to make a convincing case that they can continue to do well with sharply higher interest rates.

The result is that while we do expect to see one more quarter-point hike from both the Bank of Canada and the Federal Reserve in 2019, that’s likely it for the cycle. Indeed, in 2020, when U.S. fiscal policy is slated to turn modestly towards a tightening, and certainly we’ll see the full saving of the impact of the early era fiscal stimulus, we might well see the Fed cut interest rates a quarter-point to keep the economy from dipping into more of a slowdown than they were bargaining for.

The flat yield curve is certainly starting to pick this up. It’s not necessarily warning you of recession, but it is a message in markets that they don’t see the need for a lot more rate hikes at the front end of the curve, which is why short rates have gotten close to longer-term rates. And there’s a second factor behind that as well, which is that the normal, the new normal for long-term interest rates is lower than it was in the ’70s and ’80s because markets no longer fear the risk of an escalation of inflation and no longer demand the same set of term premium to lock in money over the longer term.

As a result, I think you have to discount a little bit the warning signs that people see in terms of a flat yield curve and whether it’s telling you that a recession is coming. If we were to see a steeply negative  slope for the yield curve, coupled with a softening in employment data, I think those are the kind of signals we’d be looking for rather than just the yield curve slope to indicate that a recession is on the way. And we don’t have either of those signals yet for either the U.S. or Canada.