The flattening yield curve: What it means

In an economy with an interest rate policy target (most countries, including the US), rates, in general, give us a straightforward forecast of the most likely value for future policy rate level.

We currently have a situation in the US Treasury market where yields are compressing together across maturities, i.e. the yield curve is flattening. The compression is most pronounced in the near-dated end, where 1- and 2-year instruments are yielding much closer to 5-year bonds than they were in, say, 2014.

The yield curve is not currently flat, just moving closer to a position of moderate flatness, indicating that policy rate adjustments are mostly over, until something happens to change that forecast.

The chart below shows the current state of the yield curve, compared with recent history. Even from May 2017, the curve has flattened. The flattening is especially marked when compared to yield curves before the initial rate hike in December 2015. Note however, that with the exception of the January 2013, and to a much lesser extent, the January 2015 example, how stable the 5-year yield has remained. The interpretation here is that in recent years markets have expected the Fed funds rate to be about 1.75% in the “medium” term.

We will keep an eye on the yield curve and see if it compresses further. Presumably, it will slow in coming months, as the Fed has burned up most of its ability to raise rates without spooking markets. Declining yield curve steepness should be seen as a barometer of the Fed’s progress in reaching a sustainable value for the Fed funds rate.

Wishful thinking

We should try to think of plausible, upside scenarios from time to time, for our own health. The 5-year yield, which has been so stable, could be a harbinger of one such scenario.  It is plausible that deregulation will snatch low hanging fruit on the supply side, leading firms to cut prices. The Fed would then be faced with a situation of intolerably low inflation, leaving them impotent to squelch any endogenous accelerations in the economy. They may even be forced to push the economy along, maybe boosting NGDP growth above 4.5%. This is entirely speculative but if it did happen, the 5-year yield would probably move north, well in advance.

Naturally, we also use yield curve information in our estimate of the market´s NGDP forecast.

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