Why you can expect the upward-sloping yield curve to continue

By

Nov. 20 2020, Updated 2:44 p.m. ET

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.

For the yield curve to flatten or invert, intermediate-term (IEF) and long-term (TLT) yields need to fall, as short-term yields can’t decrease further.

Given that the economy is improving, this scenario is highly unlikely—especially over the short-to-medium term.

Article continues below advertisement

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.

However, as the economy improves, corporate profitability improves, leading to a contraction of credit spreads for investment-grade (LQD) and high-yield bonds (HYG).

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.

To learn more about important strategies for fixed income investment, check out Market Realist’s Fixed Income ETFs page.

Advertisement

More From Market Realist

  • CONNECT with Market Realist
  • Link to Facebook
  • Link to Twitter
  • Link to Instagram
  • Link to Email Subscribe
Market Realist Logo
Do Not Sell My Personal Information

© Copyright 2021 Market Realist. Market Realist is a registered trademark. All Rights Reserved. People may receive compensation for some links to products and services on this website. Offers may be subject to change without notice.