The Federal Reserve (Fed) heard the market’s alarm and shifted its stance, but the U.S. yield curve hasn’t woken up yet.
As shown in the LPL Chart of the Day, the spread between 2-year and 10-year Treasury yields has hovered around 15 to 20 basis points (bps) (.15–.20%) over the past few months, the lowest level since 2007.
Tightening Fed policy and muted growth and inflation expectations have driven yield curve flattening amid rising interest rates the past few years, a shift known as a “bear flattener” that isn’t necessarily ominous for U.S. economic potential. However, stagnant longer-term yields at the end of last year increased speculation that the Fed’s gradual rate tightening plans could derail the expansion. After all, an inverted yield curve (or long-term rates falling below short-term rates) has preceded each of the nine recessions going back to 1955.
Now, the Fed has promised patience in deciding on future hikes, but the yield curve remains historically flat. Short-term rates have settled into a range that aligns with a Fed pause: The 2-year yield has closed within 10 bps (.10%) of the upper-bound fed funds rate for 31 straight days, the longest streak since 2013. However, 10-year yields have fallen into their smallest year-to-date range since 1974, even as market expectations and data point to rising inflation.
“We see the stall in long-term rates as a clash between steady economic growth and rising inflation expectations on one hand, and higher global demand amid lower yields in other major regions on the other,” said LPL Research Chief Investment Strategist John Lynch. “However, we think sound economic fundamentals will eventually prevail over global uncertainty.”
We expect the 10-year yield to end 2019 in a range of 3–3.25% as growth stabilizes and inflationary pressures continue to rise. We wouldn’t be surprised to see the 2-year yield climb slightly if stronger growth forces the Fed to implement one hike in the second half of the year. Based on our forecast, we’d expect to see 25–50 bps (.25–.50%) in steepening through the end of the year.
Even if the yield curve inverts, an economic recession isn’t necessarily imminent. Since 1970, a recession has started an average of 13 months after the 2-year yield and 10-year yield spread fell into negative territory.
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