Steady Fed and a bond market curveball

The first quarter of 2018 saw activity in the bond market that hasn’t been seen since prior to the 2008 recession. Rates on the 2-year U.S. Treasury rose to 2.28 percent and the 30-year Treasury broke through 3 percent and stayed there. The low volatility of 2017 appears to be behind us, and markets are again getting used to bond yields that move with economic news, rather than language out of Washington, DC.

In March, the Open Market committee of the U.S. Federal Reserve raised the Fed Funds rate to 1.50 percent– 1.75 percent, as expected. Their commentary highlighted positive events that could presage future increases down the road. Markers to look for in coming months include:

  • With tax cuts and a spending package passed this year, the Fed may revise up its economic forecasts and interest rate projections.
  • The Committee could raise Gross Domestic Product (GDP) forecast by 0.5 percentage points for 2018, and 0.3 percentage points for 2019. This while raising its employment and inflation forecasts only modestly.
  • Expect their projections for future rate increases to imply four hikes in 2018, and two or three more in 2019.

Fed Chair Jay Powell also suggested that economic headwinds are turning to tailwinds, and that the Committee will strike a balance between avoiding overheating and bringing the inflation rate up to their 2 percent target. He also believes that unemployment can go lower as the labor force participation rate increases, as incentives for employment increase.

Meanwhile, a key bond market barometer that previously suggested faster economic growth has reversed course. The “yield curve” is calculated by measuring the differential between long-and-short-term Treasury yields. Investors keep an eye on it because it can be a good signal for the future direction of the economy. When it steepens (long rates rise relative to short), it can indicate faster growth. When it flattens (short rates rise relative to long), it can signal a slowdown or recession. Right now it is flattening. Trade web data show (see chart on back) that the differential between the 30-year yield and the 2-year yield shrank to 0.75 percentage point during the quarter, the lowest level since January.

Though some question the curve’s forecasting power, the Fed pays close attention, particularly when the yield curve “inverts,” and short-term rates move above long rates. According to the Federal Reserve Bank of San Francisco, “Periods with an inverted yield curve are reliably followed by economic slowdowns, and almost always by recession.” An inverted yield curve isn’t a 100 percent predictor of recession, but it is right more than it is wrong, so it deserves our attention. The curve has not inverted yet, but we’re watching.