The FOMC is widely expected to lower its Fed Funds target rate by 0.25% when it meets next week. This won’t be a surprise. The market has been anticipating an interest rate cut. So, the cut itself will be no big deal.
It will, however, have enormous implications.
Look at this long-term monthly chart of the yield curve…
The yield curve has been inverted for more than two years. In other words, the abnormal condition where short-term rates are higher than long-term rates has persisted longer than any other time in the past four decades.
Indeed, the yield curve has been inverted for so long that it “feels” almost normal. Nobody pays much attention to it anymore.
All the worries about an inverted yield curve being a reliable predictor of a recession have been silenced. After all, it has been two years – and the economy seems to be running along just fine.
But, as we’ve pointed out multiple times over the past two years, it’s not the inversion that signals trouble ahead. Instead, the problems occur when the yield curve shifts back into positive territory.
Trouble Ahead
Just look at the three previous occurrences on the chart. The yield curve shifted into a positive state in early 2001, late 2007, and early 2020. Each time, the U.S. economy dipped into a recession.
And, each time, the stock market suffered a significant correction.
The depth and duration of those corrections matched the depth and duration of the yield curve inversion.
So, it’s worth noting that the recent yield curve inversion was the longest and deepest of the past 40 years.
Astute readers will notice the yield curve is currently inverted by only 9 basis points. So, when the FOMC lowers its Fed Funds target rate by 25 basis points next week, the yield curve will shift positive.
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That doesn’t mean the stock market will start selling off right away. This aging bull might still be charging for the next few months.
But, if the stock market follows the same script that played out when the yield curve shifted previously, then 2025 is going to be a tough year.
Best regards and good trading,
Jeff Clark
Editor, Market Minute
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