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Gary Shilling: Is the Fed inverting the yield curve and causing a recession?

Another interesting phenomenon is the declining yield spread between 10-year and 2-year Treasury. Most of the recent narrowing is due to rising 2-year yields, reflecting expectations of further Fed rate-raising. But 10-year yields have also fallen from 2.45% at the end of 2016 to 2.38%, probably due to continuing deflationary expectations as well as foreign demand for long-term Treasurys. Inflation continues to undershoot the Fed’s 2%

Target.

This narrowing of yield spreads is also shown by the fact that since the Fed started raising the fed funds rate in December 2015, the yield on 30-year Treasurys has actually fallen. This situation is indeed abnormal, but reflects unusual forces at work in global economies and financial markets. Our analysis of the entire post-World War II era reveals that, on average, a one percentage point rise in the fed funds rate leads to a 0.42% rise in 10-year Treasury yields and a 0.30% increase in 30-year yields. That's the reverse of recent action.

The narrowing in yield spreads is also interesting since it often is the prelude to recessions. In the past, when the Fed jacked up short-term rates in response to what it saw as an overheating economy, the yield curve inverted with short rates exceeding longer-term yields and a recession followed every time.

After the 2013 “taper tantrum,”—the market’s violent reaction to the Fed Chairman Ben Bernanke’s hint that the Fed might reduce its massive purchases of securities—the central bank is moving very cautiously to raise interest rates and reduce its huge portfolio of securities. Low inflation is also a reason for Fed caution.

Still, if the Fed persists in tightening, a recession is in the cards. By our count, in 11 of 12 post-World War II attempts by the central bank to cool the economy without upsetting the apple cart, a recession resulted. The only soft landing was in the mid-1990s. Now, in addition to raising interest rates, the credit authorities are selling off their horde of assets for the first time ever. It may be some time before the moment of truth, but what are the odds of a soft landing?