PMC Weekly Review - May 19, 2017
At its most basic level, the term structure of interest rates, or the yield curve, as it’s more commonly known, represents prevailing interest rates the US Government must pay to issue new debt of various maturities. In turn, these interest rates influence the cost of funds for corporations and individuals. Consequently, the yield curve has a major influence on future economic activity. The flipside of this influence is that interest rates can also reveal a lot about economic actors’ expectations for future growth, inflation, and monetary policy. Recognizing this, what are recent yield curve trends telling us about the bond market’s expectations for the US economy, and how do these expectations compare to those of the recent past?
The most notable recent shift in the structure of treasury yields occurred after the election of Donald Trump to the Presidency and Republicans’ consolidation of legislative control in Washington, D.C. The yields on long-term treasuries spiked, resulting in a significantly steeper yield curve, following more than 18 months of flattening. The trend toward a flatter yield curve resulted from a number of factors, including expectations of low growth and inflation and strong foreign demand for relatively high risk-free interest rates. The bond market’s response to the November election, however, indicated expectations for an imminent return to robust economic growth and higher inflation driven by tax cuts, deregulation, and infrastructure spending.
Since the election, however, both the Trump administration’s and Congress’ inability to make significant progress on their goals has become more evident in the treasury market, witnessed by the return to a flattening trend. The yield differential between the 10-year Treasury Bond and the 2-year Treasury Note, a common measure of yield curve steepness, reached pre-election levels this week, after having fallen since the beginning of the year. Forward inflation expectations, as measured by 5-year, 5-year forwards, have settled near their own pre-election levels, indicating that investors’ aggregate expectations for fiscally-driven reflation have deteriorated substantially. Therefore, in the absence of a large infrastructure spending package, fiscal policy is unlikely to drive sizeable price increases or result in higher treasury yields.
Although these prior developments have pertained to fiscal policy and primarily influenced intermediate- and long-term treasury yields, another, more-subtle shift stemming from monetary policy has occurred in the short end of the curve. Three hikes into the Fed’s current tightening cycle, and with two more hikes in the fed funds rate projected in 2017, treasury bills have come untethered from their previous anchor of essentially 0%, and the yield on the 2-year Treasury Note has more than doubled since this time last year. Indeed, the Fed’s continued elevation of its key policy rate usually coincides with a flattening of the yield curve as future growth expectations decline. With monetary policy’s influence currently constrained to shorter maturities, the impending runoff of the approximately $2.5 Trillion in treasury bonds and the $1.8 Trillion of agency mortgage-backed securities (MBS) currently held on the Fed’s balance sheet could potentially lead to a steepening of the yield curve, depending on how it is implemented. However, as details on the timing and nature of the runoff are still unknowns, this is a topic for another day.
With the exception of higher short-term treasury yields due to tighter monetary policy since November’s election, the treasury market has essentially returned to its pre-election state. Considering the current tempest swirling around the Trump
administration, it isn’t clear how or when it will be able to work with Congress to implement meaningful stimulus, and the bond market reflects that reality. However, markets are constantly in flux, pricing in news as it develops. Today, treasury yields reflect an economic reality not so different from the one near the end of President Obama’s tenure. As a result of either monetary or fiscal policy, that reality could shift considerably over the next few months. Unfortunately, there are no tea leaves to read that could tell us what the future holds, but, rest assured, when it arrives, investors should be able to read it in the treasury curve.