A record-low Fed funds rate ensures a normal yield curve
The Fed has maintained loose monetary policy since December 2008 by keeping the target Fed Funds rate low at 0% to 0.25%. The low Fed funds rate coupled with the Fed’s bond buying program has resulted in yields across maturities hitting record lows. The near-zero short-term (BIL) yields have ensured a normal upward sloping yield curve in the current environment.
Given that the economy is improving, this scenario is highly unlikely—especially over the short-to-medium term.
The Fed is still a ways from achieving its dual objective of 2% inflation and full employment. Inflation has remained low at 1.5% through March 2014, still far from the target, while the unemployment rate remained at 6.6% for March 2014, considerably higher than the estimated optimal rate of 5.2% to 5.6%.
So tight monetary policy doesn’t seem to be in the cards—at least in the near future. The yield curve should remain upward-sloping for some time.
With improvements in the economy, the Fed will consider increasing the short-term rate. As interest rates and bond prices share an inverse relationship, Treasury bond prices are expected to fall on a rate hike.
As yields on corporate bonds are an addition of yield on corresponding Treasury bonds and the credit spread, investors should carefully gauge the effect of rising interest rates and contracting credit spreads when investing in corporate bonds in an improving economy.
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