In 2019 the Federal Reserve’s FOMC (Federal Open Market Committee) did a complete 180 from many expectations at the end of 2018. December of 2018 saw the FOMC increase the Fed Funds rate 25 basis points to a range of 2.25%-2.50%. At this time, along with the Federal Reserve’s guidance, many were expecting a continued upward trajectory in rates for 2019. However, leading up to December of 2018, the U.S. Treasury yield curve had been flattening. To many, this was a potential warning sign that maybe a continuation of the upward trajectory in interest rates was not such a sure thing.
During the first half of 2019, the FOMC remained on hold with respect to further increases in the Fed Funds rate and the yield curve continued to flatten. Global economic weakness and political uncertainties such as the trade negotiations were often cited as reasons for the pause. Beginning on August 1st of 2019, the FOMC began reducing the Fed Funds target range and reduced the range by 75 basis points over the following three months to where the range currently stands at 1.50%-1.75%. In August of 2019, the spread between 2 year and 10-year U.S. Treasury yields reached a slight inversion point of -5 basis points. Since that time, this spread has reversed in conjunction with the Fed Funds target range decreases and is a positive 30 basis points at the time of this writing. Furthermore, the FOMC has paused reducing the Fed Funds target range since the last reduction on October 31st of 2019.
The Current Environment
The last FOMC meeting was December 11th of 2019. The press release from this meeting cited a labor market that remains strong and that economic activity has been rising at a moderate rate. Following this meeting, most Fed officials expected that the Fed Funds rate would likely remain unchanged in 2020. They still believe the risk is biased to the downside, however, further reductions would not likely occur without a material change to the downside in economic activity. At this time, markets are not expecting additional reductions in the Fed Funds target range until later in 2020 and only one reduction is being discounted in the market. In addition, as noted above, the spread between the 2 year and 10-year U.S. Treasury yield has steepened and remains at approximately 30 basis points. This spread represents the steepest the curve has been in 14 months. Does all of this mean that further reductions in short and longer term interest rates in 2020 are on pause?
Certainly, a reasonable base case outlook would be for no reductions in the Fed Funds target range in 2020 and a U.S. Treasury yield curve that remains relatively constant around current levels or maybe even steepens further. However, keep in mind how relatively quick the timeframe was from rates increasing to rates decreasing. The FOMC took back 75 basis points of Fed Funds target rate increases in a mere three month period. That represents a third of Fed Funds rate increases that had been gradually occurring during the previous several years. Many market watchers point out that every recession in the past 50 years has occurred following a yield curve inversion and no recession occurred that was not preceded by a yield curve inversion. Furthermore, often was the case in these instances where the yield curve uninverted, but a recession still followed. If history follows suit and a recession occurs in 2020 or early 2021, it is expected that the FOMC would continue moving the Fed Funds target rate down and yields across the entire term structure would continue moving down. The reasonable base case noted above may well play through during the first half of 2020 and possibly even the entirety of 2020. However, the risk for most credit unions lies in the possibility of a resumption in rates moving down and that possibility occurring sooner then the FOMC or markets are currently anticipating. Credit Unions should keep this in mind in 2020 and beyond even if the near term outlook remains or becomes increasingly complacent to the possibility.