There have been nine 25 bps rate hikes since the Fed tried to normalize short term interest rates, or Fed Funds rates, from Dec 17, 2015, the first hike to the latest of round on December 22, 2018. The short term borrowing rate rose from almost zero percent to the target of 2.25-2.5% as of now, and short term bond yields also climbed along with overnight rates. The benchmark yield of 2 year Treasury bond was near 1% when Fed made the first 0.25% rate increase on December 17, 2015, and it rose nearly 140% to about 2.39% as this note generated. However, the long bond or the yield on 30yr US Treasuries is traded at roughly 2.95%, almost the exactly where it was 3 ¼ years ago. The table below looks at the bond yield changes from the date that the Fed made the 1st hike to today.
As in previous two monetary tightening cycles, most of the rate movements or yield changes concentrated at the short end of the interest rate curve. The back end of curve, the yield on the 30yr bond barely moved at all because Fed Reserve has much direct impact on the short term interests, much less than long bond yield as it is much a function of inflation expectation and economic growth.
All major yield spreads along the Treasury bond securities have come down consistently throughout the tightening cycle, reached “inverted” for the front end of yield curve when Fed rose the Fed funds rate in last December. The yields on 5 year and 7 year bonds were lower than 2 year and 3 year bonds and Treasury bill yields, and the negative spreads between intermediate or 5 year and the short or 2 year notes have been persistent since inverted last December (green line chart below.)
When the Fed made the interest rate policy U-Turn from two rate hikes in 2019 a about three month earlier to no more tightening and “wait and see” for foreseeable future, and also ending the balance sheet runoff soon to maintain a much higher reserve balance. Treasury market rallied and the yield on the most important benchmark note 10 year note crashed down to below 2.4%, or much less than Fed funds target rate 2.5% and all Treasury bill yields, which for the first time since the hiking cycle, the inverted yield curve extended to 10 year notes. This has caused a lot of market headlines news from main street media to social network postings.
But in reality, U.S. Treasury BOND market yield curve has not “inverted” measured between the short end, or 2-year yield and the long end, 10-year or 30-year yields, the traditional bond market yield curve metrics. As the chart above shows that 2-10 year spread has been remarkably stable or totally “flat” since December, fluctuated at 10-20 bps with less than 5 bps on either direction of average 15-16 bps. If we look at the back end of the curve, or 10-30 year bond yield spreads, the curve has been steadily steepened, or bull steepened as resulted of much greater drops in 10 year note yield, the spread has doubled from about 20 bps in December to 40 bps now (see chart below dark blue line.) The whole curve, the difference between 2-30 year yield differentials also is on the rising (orange line chart below.)
So is the yield curve flattening or steepening? The answer is depending on which part of the curve one is looking at. There is no questioning that the yield curve has flattened and even inverted on the majority of tenors, but the diverging movement between 2-10 and 10-30 spreads didn’t happen very often. Last time we witnessed 2-10 spread narrowing while 10-30 widening materially was at the beginning of 2016 when the recession hit some major emerging markets which caused US manufacturing activities declined materially and Fed signaled “data depended” and didn’t raise the rate until the end of the year.
The possible explanation for seemingly contradictory movements, using 10yr note yield as a pivotal point, the yield differentials from 10yr and shorter maturities are narrowing while the spread to 30yr bond, however, is widening, are pretty evident, i.e., probably have much to do with the Fed.
- The bull flattening of the front part of curve probably is reacting to possible over-tightening policy and possibilities of policy errors, the likely interest rate policy change is rate cut.
- Because of the possible rate cut and potential monetary stimulus and liquidity injections mentioned above, there would be increasing upper pressures on the financial condition and economic activities, and eventually, price inflation expectation in long run, which would lead to rising spread for the back end of the curve.
The simultaneous bull flattening in the front and bull steepening on the back end is not very common, bull steepening of the back-end curve tended to lead the overall yield curve steepening coming out of “inversion” in previous two Fed policy cycles. We all know what happened in the past, what will happen and when it would happen probably are the most challenging questions.