Will the Treasury yield curve flatten or steepen?

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Nov. 20 2014, Updated 8:00 a.m. ET

Barbells and the Fed’s rate tightening cycle

The Fed is widely expected to raise rates in 2015. This would result in rising short-term yields. Long-term (TLT) yields, on the other hand, depend on other factors, including economic growth and inflation expectations, besides increases in the federal funds rate. As we mentioned in the previous part of this series, they’ve also benefited from significant demand for safe-haven securities this year. Let’s analyze the outlook for both inflation and economic growth.

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Economic growth and the yield curve

US GDP growth has averaged ~2.5% from 1994 to 2014 in Q3. GDP growth is expected to range between 2.0% and 2.2% in 2014 and between 2.6% and 3.0% in 2015.[1. US Federal Reserve’s Statement of Economic Projections, September 2014] The Fed projects long-term growth at 2.0%–2.3%. This is slightly below the historical trend.

Inflation and the Treasury yield curve

The Fed’s favored inflation measure, the change in the Personal Consumption Expenditure Price Index (or PCEPI), came in at 1.4% in September 2014. It’s well short of the Fed’s long-term target of 2%. Inflation last touched 2% in April 2012. The current trend for declining energy and commodity prices due to a supply glut may exacerbate this trend and may actually worsen headline inflation in the coming months.

The US economy currently also has an output gap, estimated at 3.5% of potential GDP. With excess capacity in the economy and falling energy prices, inflation is unlikely to reach its 2% goal in the near term.

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With both economic growth and inflation running below long-term trends, long-term Treasury yields are unlikely to rise as much as short-term rates, when monetary tightening begins. Besides, longer-term Treasuries are likely to experience significant demand from overseas due to monetary easing programs announced by the Bank of Japan and the European Central Bank.

But low inflation may not be enough for the Fed to refrain from monetary tightening. Labor market improvements and sustained economic growth for several quarters now make a compelling argument for increasing rates from the unprecedented lows. Further, low commodity and energy prices are likely to benefit US firms and consumers by lowering costs. This would lead to an increase in profits and consumer spending and boost growth.

An increase in the federal funds rate is expected next year. Treasury (UST)(SHY) yields at the short end of the curve are already moving up in anticipation. But they’re still well below pre-recession norms. They’re likely to move up further as the Fed starts the cycle of rates increases.

An increase in short-term rates, coupled with long-term rates that don’t rise as much, would imply a flattening of the yield curve, benefiting investors employing a barbell fixed income (BND)(AGG) strategy. A ladder or a bullet strategy wouldn’t perform as well as the barbell, as they won’t have the equivalent exposure to take advantage of both the short and long ends simultaneously.

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