The Fed Rate Cut’s Impact on the Yield Curve

On September 18 the Federal Reserve announced that it was cutting its target policy rate by 50 basis points, from an original range of 5.25% - 5.50% down to the new range of 4.75% - 5.00%. The markets had been expecting a cut, but they were unsure whether it would be a more conservative 25 basis points versus the actual cut of 50. The move immediately led to a steepening of the yield curve. I explain all of this in the present article, and also show the latest from the “Sahm Rule,” which is also indicating a looming recession.

The Sahm Rule Indicator Is Flashing Red

Developed by Claudia Sahm, the Sahm Rule Indicator signals the start of a recession when the three-month moving average of the national unemployment rate (U3) rises by 0.50 percentage points or more relative to the minimum of the three-month averages from the previous 12 months.” The following chart from the St. Louis Fed shows the historical relation of Sahm’s indicator to US recessions:

As the chart indicates, the problem with using Sahm’s indicator as a leading one is that it doesn’t zoom through the roof until well after the recession is underway.

Even so, the current reading (as of August 2024) was higher than any prior point, back through 1960, that was not soon followed by a recession. In other words, since 1960, whenever the Sahm Indicator has been as high as it currently is, a recession soon followed.

Although the Sahm Indicator is useful as an independent signal of recession, I don’t put too much stock in it because it’s largely just a momentum gauge. Essentially, it says that once unemployment rises rapidly enough, it keeps going up. But it doesn’t shed much insight on what makes unemployment start tracking up in the first place. For this reason, I personally put far more weight on the power of the inverted yield curve as a leading recession indicator.

The 10yr – 2yr Treasury Yield Spread

There are two popular measures of the yield spread, in the context of looking to the yield curve as a warning light of an impending downturn. One of these is the spread between yields on the 10-year Treasury and the 2-year Treasury. The historical pattern is that this spread typically inverts soon before a recession. On our current cycle, the 10yr-2yr inverted back in the summer of 2022, but now has become uninverted since early September:

However, the academic literature concludes that the particular spread of the 10-year minus the 3-month T-bill yield has a better track record (specifically, no false negatives and one borderline false positive) going back to the 1960s. So let’s now look at this measure.

The 10yr – 3mo Treasury Yield Spread

When considering the 10yr-3mo spread, the inversion occurred in October 2022. This particular spread remains inverted, although it has steepened appreciably since the depths of the inversion back in May 2023. The following chart illustrates:

In light of my other views and the behavior of the Treasury security market (analyzed in the next section), I believe the Fed will cut again in the near future, pushing down short rates yet again and possibly contributing to a gentle rise in long rates. Eventually the 10yr-3mo will become uninverted, and the recession will soon be declared officially to have begun.

The Reaction of the Treasury Security Market to the Fed Rate Cut

The following table shows the evolution of the Treasury yields for select maturities over the course of September. Remember, the Fed announced its 50-basis-point cut on September 18, highlighted in gray:

The first column in the table shows that the federal funds rate—which is the rate banks charge each other for overnight loans of reserves—was constant at 5.33% until the day of the cut, after which it held at 4.83%. (Notice that this is within the Fed’s official target range of 4.75% - 5.00%.)

Looking at the values the day before versus the day after the announcement, we see that Treasury yields went down for the 1mo through 3mo, but there was no change in the 2yr yield. In contrast, the yields on the 10yr and 30yr rose from the day before to the day after the announcement. Presumably, what’s happening is that the Fed’s looser policy can increase the supply of loanable funds and hence push down short-term yields, but the extra anticipated price inflation from this looser policy translates into a higher required (nominal) yield on longer-dated Treasuries, to compensate for the reduced purchasing power of the USD in 10 and 30 years.

Whatever the reason for the different impacts on the left and right end of the curve, it is clear that the Fed announcement contributed to a steepening of the yield curve, as the last two columns in the table indicate. As we discussed above, the spread on the 10yr-2yr is already in positive territory, while the 10yr-3mo has moved closer.

Conclusion

In light of the Fed’s rate cut and the reaction of the bond market, I am sticking with my economic outlook given back in April on these pages: Specifically, I don’t see a surge in consumer price inflation (absent outbreak of war, which may very well come) coming from monetary factors, and I think the US is headed into a bad recession. The happy talk of a “soft landing” ignores the stark parallel between our current economy and that on the eve of the financial crisis.

Dr. Robert P. Murphy is the Chief Economist at infineo, bridging together Whole Life insurance policies and digital blockchain-based issuance.

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