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The Primary Cause of Yield Curve Flattening

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Interest rates and inflation

The pace of interest rate hikes and inflation rate growth have a profound influence on the US yield curve. The US Fed has been communicating its intent to increase interest rates from the current ultra-low level to a target rate of 2.5% over the next few years. The conditions required for tightening, outlined by the Fed, are the improvement of the US economy, and US inflation (TIP) moving towards the Fed’s target of 2%. The Fed has been increasing interest rates despite the slow growth of inflation (VTIP), and this disconnect is one of the key reasons for longer-term (TLT) rates not changing or falling further.

A closer look at the inflation conundrum

In the last few quarters, inflation has remained stubbornly low. A closer look at constituents tells us that most gains have been due to rising fuel (USO) prices. There are no obvious reasons for inflation (SCHP) staying low despite unemployment falling, which is confusing to many economists and the US Fed. This uncertainty about future inflation growth is leaving investors wondering if the Fed will continue tightening as it has projected, which would lead to stagnant long-term yields and a flattening yield curve.

Why is inflation so important?

Countries’ economic improvement depends partially on the rate at which prices increase. If prices don’t increase, there is no rush for consumers to purchase goods, no incentive for manufacturers to increase production, and no scope for increasing wages. Such a scenario could leave the economy stagnant or move it into a recession, which is why the Fed has set an inflation target of 2%—it is the optimal rate for steady economic growth. In the next part of this series, we’ll discuss the risks of yield curve inversion.

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