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An Interest Rate Hike Could Cause a Flatter Yield Curve

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The picture for shorter term interest rates is much different. These short term rates, such as the two-year Treasury, are highly influenced by the Federal Funds rate. As the Fed begins to increase their short term target rate, we expect that two-year rates will begin to rise. Current projections have the Fed beginning hikes around June. Short term rates are likely to rise as we approach this date, and continue to rise for the rest of the year.

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The net impact I expect is to have stable to rising longer term interest rates, and rising short term interest rates. Bond investors refer to this as a “flattening”; the slope of the yield curve is getting flatter as the short end rises more than the long end. This turns out to be a very common occurrence during Fed tightening cycles. Here we can see what happened with the steepness of the yield curve and the Fed Funds rate during the last rate hikes in 2004-2006:

We saw the beginning of this flattening in 2014 as the yield difference between two- and 10 year Treasury rates decreased by 1.14%, from 2.64% to 1.50%. As the yield curve flattens, I would expect this spread to continue to narrow.

The rate-hike could cause a flatter yield curve.

Market Realist – The rate hike could cause a flatter yield curve.

The graph above compares the spread between the ten-year Treasury (IEF) yield and the two-year Treasury (SHY) yield with the federal funds rate for the previous period of rising rates.

As you can see from the graph, the two are inversely related. The Fed usually hikes interest rates when the economy is on a strong footing and inflation rates are beginning to nudge higher.

A lower spread or flattening curve indicates that expectations for future inflation are falling, and that the economy is deteriorating, as higher rates rein in inflation and reduce the general demand in the economy. Since inflation erodes the future value of an investment, investors demand higher long-term rates of return to make up for the lost value, increasing the spread.

When inflation is less of a concern, this premium shrinks. When interest rates started rising in 2004, the spread contracted—and actually got negative for a while—for the same reason. This trend made long-dated Treasuries (TLT) less attractive.

Generally, when the spread compresses, equities (SPY)(DIA) don’t perform well, as the economy is usually deteriorating.

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