Ignore the Fed’s Yield Sign at Your Peril
If the Federal Reserve’s rate projections come true, the yield curve is bound to get flatter
By Justin Lahart
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The Federal Reserve is telling investors it will flatten the yield curve. They should listen.
Last week, policy makers stuck to a projection that they will raise their target range on rates by another quarter point this year. But they also lowered their median projection of where they think rates will eventually be to 2.75% over the longer run versus their June forecast of 3%.
That matters to the bond market because Treasury yields reflect investors’ expectation of what overnight rates will average across the maturity of Treasurys, plus the “term premium,” the extra yield investors demand for the risk of lending over a longer term. Historically, term premiums have been positive but lately have been negative.
Based on the Fed’s projected rate path and current term premiums, the 10-year Treasury yield seems about right. Nor should yields rise much as the Fed raises rates, because those rate increases would only raise the average level of short-term rates over the 10-year’s maturity slightly. Average rates over shorter maturities, such as for the 2-year Treasury, would rise more. The Fed’s projections suggest the yield curve will flatten.
LOWERING THE BAR
Median projection for the longer-term federal-funds rate
Fears that a flat curve is an economic distress signal may not pan out, but it does lead equity investors to reduce risk, points out Cornerstone Macro’s Roberto Perli. Shares of banks and credit-dependent firm often underperform.
The Fed’s expected rate path might not come true. Low inflation could lead it to raise more slowly. High inflation could do the opposite. And even if the Fed turns out to have been right, an increase in term premiums could alter the curve’s shape. But for now, investors should be careful not to get flattened.
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