22 SEPTEMBER / OCTOBER 2017 Yield Curve Behavior Flattening in the face of the Fed DIRECTORS / SENIOR MANAGEMENT If you want to gauge market expectations and forecasts of future short-term interest rates, a good place to start is the yield curve. According to the expectations hypothesis, a long-time favorite of economists, the shape of the yield curve at any moment in time reflects investors’ forecasts of future interest rate levels. A positively sloped curve implies that short-term rates are expected to rise in the future, a downwardsloping (or inverted) curve suggests the expectation of lower rates, and a flat yield curve represents a market consensus for stable yields. Remember, though, that nothing about financial markets is static. The curve (and its shape) is constantly changing, as expectations ebb and flow. The yield curve can steepen, flatten or go inverted in anticipation of Fed policy changes or inflation expectations that may take a long time to come about, if they occur at all. Still, investors are wise to make note of trends in the changing rate structure and consider what it tells us about the future. The temptation. If the curve is steep, it tempts you to extend asset duration, because you can pick up meaningful yield by doing so. Similarly, when the curve is flat, you have no incentive to extend duration, since you are paid the same rate for staying short. Thus investors are induced to extend duration when the curve is very steep, and shorten duration when the curve is flat or inverted. Sometimes this works out fine, depending on the point of the curve to which you extend or shorten. But mistakes are often made when we forget to consider what the curve is telling us. The reality. When the curve is steep, it is because the market is expecting short-term rates to rise. When the curve is flat or inverted, it is because the market expects rates to stay the same or fall. Though it isn’t infallible, the slope of the yield curve has been a pretty good predictor historically of what will happen to the general trend of interest rates. So, counter-intuitive though it may be, a steep curve can be viewed as a signal to reduce duration (since rates are expected to rise), while a flat curve is a signal to extend (since rates are expected to fall). The history. Over the last two interest rate cycles, we’ve seen periods of yield curve inversion and periods of extreme steepness. In each case, the slope of the curve accurately forecast the direction of rates over the next year, particularly during the tightening phase. Once the Fed began to tighten, the curve flattened and eventually inverted. Then we saw rates head lower, though not immediately, as the economy weakened. Today. We’ve seen substantial yield curve flattening in the last three years. The curve appears to be exhibiting classic signs of late-cycle behavior, but with an important new wrinkle. In the last year and a half, the Fed has raised the funds rate three times (soon to be four), which of course pushes up the short-end relative to longer maturities. Simultaneously, economic data since the beginning of the year has been lackluster, and inflation sluggish. So while the Fed seems intent on “normalizing” rates by moving the short end higher, it runs the risk of moving too far too fast, a potential problem for an economic cycle that’s now nearly a decade old. Then there’s the unprecedented situation regarding the Fed’s enormously bloated balance sheet, a legacy of quantitative ease, which is expected to gradually Jeffrey F. Caughron President and CEO The Baker Group jcaughron@GoBaker.com The Baker Group is a Preferred Service Provider of the Indiana Bankers Association and an IBA Diamond Associate Member. Article author
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