U.S. Yield Curve and Risk of a Liquidity Trap

The Fed, after its most recent meeting reiterated its plans for the front end of the yield curve for the remainder of the year and into next year. Barring some unforeseen disaster in one form of another, of course. Market participants can expect at most three interest rate increases this year. Since the unwind of Quantitative Easing began, the Fed has been loosening its grip on the longer end of the curve, which has allowed for a clearer dissemination of market expectations through pricing data. My regression analysis of the last year's price of the 10-Year U.S. Treasury Note Futures, suggests a period of stable to rising prices in the medium-term. Stable to rising prices for 10-Year U.S. Treasuries means stable to falling interest rates for that segment of the yield curve. Pair that with the raising interest rates on the very front end of the curve, the trend of yield curve flattening that has been unfolding in bond markets is set to accelerate.

When the Fed raises short-term interest rates in a healthy economy, with growth on its horizon represented by a steepening yield curve, the rate increase transmits throughout the entire curve and pushes down all bond prices. In normal financial markets, investment capital would flow out of bonds and into stocks, raising equity prices and further reflecting expected economic growth. Apparently, we don't have a healthy economy, with growth on its horizon, or normal financial markets. With the Quantitative Easing unwind well underway and the now-apparent fact that the U.S. economy cannot support equity prices at current levels on its own, stock markets around the world are revaluing. Now for a bit of normalcy, falling stock prices will result in investment capital flowing into bonds. More specifically, the 10-Year U.S. Treasury Note for its perceived safety and liquidity, which will push the price up and interest rates down.

As the Fed continues along its intended course of interest rate increases, inflation expectations of market participants and businesses will continue to remain subdued. This translates into lower prices of inflation hedges like gold, and even lower input costs starting with oil. From the position of businesses, even with shortages of qualified labor, they don't have enough of an incentive to raise wages because they don't anticipate significate or continuous price increases in the near future.

My expectation is that as losses mount in U.S. equity markets, investors will have to liquidate foreign holdings, putting continued pressure on global equity markets, both developed and developing. In addition to liquidating foreign holdings, U.S. investors will repatriate cash to cover margin calls and rebalance leverage ratios by selling foreign currencies and buying U.S. Dollars. Dollar inflows will become exacerbated if the selling in equity markets accelerates and triggers a flight-to-safety reaction in market participants. In this scenario, the Fed will be forced to divert the course of monetary policy. And, if as the flattening yield curve suggests, a slowdown in U.S. economic growth or even a recession is pending, then the Fed does not have very much room to maneuver before they're back to a Quantitative Easing policy. The real definition of a Liquidity Trap.