This Flat Yield Curve Is No Mystery, According to a Fed Study

Updated on
  • San Francisco Fed research blames low inflation, neutral rate
  • There’s some risk that term premium could rise abruptly
Northern Trust CIO Says High-Yield Bonds Not in Trouble

This isn’t Alan Greenspan’s yield curve.

The gap between short and longer-term interest rates has been narrowing even as the Federal Reserve raises its policy rate, a trend that echoes the so-called “flattening” of the curve between June 2004 and December 2005. Then-Fed Chairman Greenspan called the mid-2000s episode a “conundrum,” but the leveling out is no mystery this time around, Federal Reserve Bank of San Francisco researcher Michael Bauer writes in a note called the Economic Letter.

Low inflation and neutral interest rates as well as political uncertainty are all weighing on longer-dated bond yields, keeping them low even as the Fed boosts the cost of borrowing in the near-term, Bauer writes. That’s important, because it means that if price pressures pick up quickly, investors could begin to demand better compensation for holding longer-dated securities -- reversing the flattening and potentially dinging stock market valuations, which are based partly on the low level of yields in the bond market.

“Perceived inflation risk could reverse its course quickly if inflation suddenly trended up,” Bauer says in the note. “Similarly, if investors’ expectations about the Fed’s balance sheet were to change suddenly, or if investor sentiment about the relative attractiveness of Treasuries deteriorated for other reasons, the term premium could rise quickly.”

The report came as the yield spread between five-year notes and thirty-year bonds continues to shrink, driven primarily by an increase in rates on the shorter-dated securities. The gap fell below 70 basis points on Monday, its narrowest in a decade.

Inflation has been low this year, with the Fed’s preferred index posting a 1.6 percent gain in September, well below the central bank’s 2 percent goal.

Market-based indicators suggest that investors are starting to doubt whether inflation will accelerate. When investors expect prices to rise, they require extra return to hold longer-dated securities because of the risk that price gains will erode the investments’ value. But if they see a greater risk of tepid inflation progress, they’re willing to pay extra to hedge against low inflation -- driving down longer-term bond yields and flattening the curve.

Likewise, Fed officials have gradually marked down their forecasts for how high they’ll ultimately lift their overnight policy benchmark. The shift reflects a growing sense among policy makers that the neutral rate -- the one that neither stokes nor slows growth -- has declined and will stay low. Expectations about future short-term rates are a key determinant of long-term yields, so as markets followed the Fed’s lead, it probably helped to flatten the curve, Bauer writes.

Finally, expectations for fiscal stimulus drove up bond yields when Donald Trump won the presidential election last year, but have since waned. The study shows Treasury yields falling on days with negative headlines about domestic politics and geopolitical risks.

— With assistance by Brian Chappatta

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