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How the Yield Curve Could Keep Flattening

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A case of a flattening yield curve

In its December meeting, the US Federal Reserve increased the federal funds rate by 0.25%, just as markets expected. The dot-plot included in the statement that followed the meeting indicated another three rate hikes in 2018.

But two members of the FOMC (Federal Open Market Committee) didn’t support the rate hike, citing insufficient inflation (TIP) growth. This was the broader concern of bond market participants as well, leading to different yield growth across the curve.

Long-term yields (TLT) have not appreciated to the same extent as short-term yields, in response to interest rate hikes and changes to the dot-plot. This led to the narrowing of credit spreads between long-term and short-term yields, resulting in a flattening yield curve.

Notably, an inverted yield curve is considered a signal of a future recession, and so it’s included in the Leading Economic Index.

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Yield spreads used in the Conference Board LEI

The Conference Board LEI (Leading Economic Index), in its economic model, uses the yield spread between the ten-year Treasury bond (IEF) and the federal funds rate (TBF) as one of its key components. According to the January LEI report, the yield spread has reduced from 1.19 in November to 1.10 in December, fueling worries about a flattening yield curve.

This credit spread has a weight of 11% on the LEI, and in the January LEI report, the yield spread had a net positive impact of 0.12 (or 12%). The contribution remains positive as long as the yield spread stays above zero.

Outlook for the yield spread

The recent events surrounding the US government shutdown has led to a sharp increase in yield spreads, with the ten-year yield rising to 2.69%—the highest level since 2014.

The focus, however, will likely remain on inflation (VTIP) growth, as lackluster growth in inflation could result in more flattening of the yield curve.

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