Balance sheet normalization

At the last FOMC (Federal Open Market Committee) meeting on September 20, 2017, Fed members decided to initiate a balance sheet normalization process starting in October. The statement at the meeting sounded hawkish, and the markets started assuming a December rate hike. Bond (BND) yields began trending higher, causing trouble for bond (AGG) prices, but the minutes of the September meeting revealed that some of the members are still concerned about lagging inflation (TIP).

Are Declining Yield Spread Worries Done for Now?

Yield spreads used in the Conference Board Leading Economic Index

The difference between the yields of the federal funds rate and the ten-year Treasury bonds (IEF) is used as one of the constituents of the Leading Economic Index (or LEI) economic model. The October Conference Board report indicated that the spread between the ten-year (TBF) and the Fed funds rate remained unchanged at 1.05% in September.

This reading is still below the long-run average, and with short-term rates expected to rise, the interest spread will probably change consistently.

How are yield spreads expected to change?

Amid heightened expectations for near-term interest rate hikes, short-term bond yields are likely to rise. Yield spread, however, could widen or narrow depending on inflation expectations. If incoming inflation data improve, the yield spread could widen, but a continued slump in US inflation could lead to a narrowing yield spread and eventually an inverted yield curve. An inverted yield curve is considered a signal for a future recession. The US economy seems far from such a scenario.

In the final part of this series, we’ll analyze the only non-leading indicator in the Conference Board LEI.

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