Bond Traders Smash Yield Curve Flatter on Fed Inflation Mystery

Federal Reserve Chair Janet Yellen said stubbornly low inflation this year is something of a “mystery” to central bankers.

Among bond traders, there was little confusion about how to react.

The yield spread between two- and 30-year Treasuries tumbled to 136 basis points after the Federal Open Market Committee decision, the narrowest since June. The difference between five- and 30-year yields touched about 93 basis points, the slimmest since July. While shorter-dated Treasuries sold off as the Fed maintained its path for rate hikes through 2018, 30-year yields fell about a basis point to 2.8 percent. 

The move highlights that, beyond the next three months, traders are still skeptical about how high the central bank can boost rates. Officials dropped their median long-term target rate projection by 25 basis points to 2.75 percent, the lowest level since the central bank began its so-called dot plot in 2012.

Sure, bond traders rushed to price in a rate hike by year-end, with the implied probability climbing to about 60 percent, from below 25 percent on Sept. 8. But they still haven’t priced in two full rate increases by the end of 2018, whereas the Fed is anticipating four by that time.

In some ways, it comes back to the long-term rate projection. Lowering it was “a big deal,” Chris Low, chief economist at FTN Financial, wrote in a note. Another key detail is that officials reduced their inflation outlook for 2017 and 2018, he said. And 2019 remains at 2 percent “because the Fed’s inflation forecast is always 2 percent in two years.”

The Fed is already grappling with tightening policy at a time when its preferred inflation metric has been below the 2 percent target level since March. That’s been a puzzle, according to Yellen, though she pointed out that inflation being low in 2017 doesn’t mean it will continue to be tame.

But until the Fed cracks the code, don’t expect 30-year yields to soar like shorter-dated maturities.

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