4 min read 21 May 18
Summary: Fed officials have been particularly vocal about the slope of the yield curve this week (most notably here and here), in particular voicing concerns over a possible curve inversion (when yields on short dated bonds rise above those on long dated bonds).
The obsession with the yield curve is curious. For one, it seems likely to become a textbook example of Goodhart’s law, which reasons that when a measure becomes a target it ceases to be a useful measure. Will this be true of the yield curve in future?
Second, as we have argued, there appears nothing especially unusual going on with the US curve. In an environment where inflation expectations are relatively stable, as the Fed Funds rate rises it is entirely normal for the curve to flatten.
There is evidence that an inverted curve predicts recession, which the Fed is right to worry about. But that is not the present signal from the bond market. The yield curve is flatter, but upward sloping.
The curve is flatter than it has been because the market’s expectations for long run inflation and real interest rates are well anchored. Most Fed watchers, for now at least, don’t think the US economy requires a Fed Funds rate much above 3.5% in the foreseeable future. This is why long dated bond yields currently sit below this level. For as long as this belief holds and the Fed lifts rates upwards towards this level, the curve will flatten. Of course, beliefs can change.
Frequent commentary by Fed officials is therefore unnecessary. The irony is that a rise in long term yields is, other things equal, a tightening in financial conditions (raising mortgage rates etc) and yet by the logic of various officials this would warrant further tightening via a higher Fed Funds rate. The logic suggests the opposite applies if bond yields fall.
What recent comments do suggest is a Federal Reserve which sees no great upward inflation threat and therefore no need to rush the gradual pace of interest rate increases. This seems reasonable and market prices now reflect meaningful interest rate increases over the next two years.
This can be seen in the higher level of the US two-year Treasury yield (2.55%) relative to today’s Fed Funds rate (1.75%). According to Fed transcripts, this spread was a yield curve indicator cited by Bernanke ahead of the 2008 crisis (when it was inverted, see figure 2).
Ultimately market expectations will wax and wane. Last week, Wolfgang at Bond Vigilantes explored how rising two-year yields has improved their risk reward profile relative to longer maturity counterparts. It remains to be seen whether this is enough to stop further flattening, but it highlights the extent to which the Fed should be wary of overcomplicating what these curve slopes imply. Just as with sports TV commentary, sometimes saying less is more.
The value of investments will fluctuate, which will cause prices to fall as well as rise and you may not get back the original amount you invested. Past performance is not a guide to future performance.