Unless the Fed Changes Course, a 2019 Recession Collision Is the Most Likely Outcome

The current level of the federal funds rate is 1.92%. As of June 13, 2018, the median estimate of Federal Open Market Committee (FOMC) members of the appropriate federal funds rate by the end of 2081 was 2.40%. This implies that the Federal Reserve has “penciled in” two more 25 basis point increases by the end of this year. If, in fact, the Fed holds this rate-increase course, I believe a recession will occur sometime in 2019. How do I know? The yield curve tells me so.

Cast your eyes on Chart 1, which shows you the behavior of the quarterly average percentage point spread between the yields on a 10-year Treasury security and 1-year Treasury security from January 1955 through June 2018. The shaded areas in Chart 1 represent periods of recession. Notice that every recession starting with the 1957-58 recession was precededby a narrowingin this yield spread to a degree that the value of the spread went negative. That is every recession starting with the 1957-58 one was precededa negativespread between the yield on the Treasury 10-year security and the Treasury 1-year security. During the January 1955 through June 2018 period, there was only oneoccasion when this negative yield spread gave an incorrect recession signal. That was from December 1965 through February 1967. During this period, the pace of real economic activity slowed sharply, but not sharply enough or long enough to result in being designated a recession by the arbiters of such, the National Bureau of Economic Research. To wit, in the four quarters ended Q2:1967, real GDP grew by 2.6%, down from 7.5% in the four quarters ended Q2:1966. As economic growth weakened, the Fed shepherded the federal funds rate down from 5.75% in December 1966 to 3.50% by June 1967, thus pulling the economy out of its nosedive. As of July 13, 2018, this yield spread stood at 0.48 percentage points. If the Fed were to hike the funds rate another 0.50 percentage points by yearend, the yield on the Treasury 1-year security were to rise by the same amount and the yield on the Treasury 10-year security were to remain the same, the Treasury 10-year – 1-year yield spread would move into negative territory.

Chart 1