U.S. Yield Curve Should Reflect Fed’s Go-Slow Easing

“Gradualism” is the word out of the central bank on rates. And that means minimal disruption of bonds, stocks and the economy.


The yield curve has begun to flatten in anticipation of interest rate increases by the Federal Reserve, and most analysts expect that to continue once the central bank acts, matching the historical trend.

But these analysts anticipate only a mild flattening, thanks to the Fed’s slow and shallow tightening campaign. And that will allow the economy’s modest growth trend to continue, the stock market’s sideways trading pattern to persist and the borrowing necessary for expansion, analysts say.

The yield curve generally flattens when the Fed raises rates. At the short end of the curve, an increase in the federal funds rate leads other short-term rates higher. As for the long end, the tightening restrains economic growth and inflation, keeping long-term rates from rising significantly.

An intense, sustained series of rate hikes can lead to an inverted yield curve that historically has signaled that recession is coming, but we’re a long way from that scenario, analysts say.

In the run-up to the Fed’s first rate hike, the gap between two-year and ten-year Treasuries has shrunk, to 133 basis points from 147 basis points on August 31. The two-year yield stood at 0.94 percent as of December 4, and the ten-year yield at 2.27 percent.

Many analysts expect the Fed to raise the federal funds rate by 100 basis points through next year, starting a series of 25-basis-point increases this month and pushing the central bank’s target for the rate to 1 percent.

Charles Lieberman, chief investment officer for Advisors Capital Management in Ridgewood, New Jersey, says such tightening would push the two-year yield up about 75 basis points and the ten-year yield up 70 basis points. That suggests another 5 basis points of flattening.

“I think the yield curve will flatten, certainly for the short term,” says Lieberman, “But I think it’s neutral for the economy, at least for a while. Rates will still be really low, so they won’t be a deterrent to borrowing.” The Fed will be very careful not to raise rates too quickly, he says. “It doesn’t want to do anything that will jeopardize the economy.”

Given the economy’s modest growth path and quiescent inflation, the Fed is “more likely to follow a gradual path,” in lifting rates, Fed chair Janet Yellen said in Congressional testimony last Thursday.

The economy grew 2.1 percent annualized in the third quarter. And the Fed’s favored inflation gauge, the personal consumption expenditures price index, advanced only 0.2 percent in the 12 months through October. Lieberman expects gross domestic product to increase 2.5 percent next year.

The rise in short-term interest rates will be good for savers, banks and other financial institutions that will enjoy higher yields on their short-term fixed-income investments, says Subadra Rajappa, head of U.S. rates strategy at Société Générale in New York.

As for borrowing, with a good portion of the home mortgage market pegged to the ten-year Treasury yield, she says, “if there’s no meaningful rise for long-term rates, there shouldn’t be a meaningful impact on household borrowing.” Consumer credit has climbed 6 percent so far this year, to $3.5 trillion as of September.

On the corporate side, long-term rates should still be low enough to encourage borrowing, Lieberman says. For some blue-chip companies, the interest rates they pay on long-term bonds will remain below the dividend yield for their stock, he says. To be sure, some companies are rushing to lock in their borrowing before the Fed boosts rates. U.S. issuance of investment-grade corporate bonds with maturities of at least ten years totaled $641.4 billion so far this year through November 24, a record high for the period.

Analysts generally don’t see a flattening yield curve hurting financial markets, because the flattening has been widely anticipated and is likely to be mild. “Markets expect the Fed to hike rates at least a few times next year, so I think the bond market already has priced for that,” Lieberman says. Bonds are unlikely to suffer much unless the Fed raises rates more than expected, he and others maintain.

The same is true of the stock market, they say. “The equity market has been going sideways this year in preparation for a rate hike. So the impact should be minimum at best,” Rajappa says.

Shyam Rajan, head of U.S. rates strategy at Bank of America Merrill Lynch in New York, says that the yield curve would have to flatten more than the 18 basis points that he expects through the end of next year to hurt the economy and financial markets.

For the yield curve to flatten further than that, the Fed would have to boost the federal funds rate by more than the 100 basis points, he and others anticipate. “To get the Fed to hike faster than is currently priced in, you need better growth and inflation data,” Rajan says.

The yield curve flattened more significantly — 155 basis points — during the past bout of Fed tightening, in 2004–’06, because emerging-markets central banks bought long-term Treasuries and the U.S. wasn’t issuing many government bonds, Rajan says. “Both of those factors aren’t there this time around.”

So don’t expect the yield curve to cause trouble for the economy, financial markets or borrowing next year.