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What Makes the Yield Curve Turn Flat or Invert?

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Factors that reduce the slope of the yield curve

It’s difficult to pinpoint a single reason for changes to the yield curve’s slope. First, any changes to the Fed’s interest rate immediately impact the yield curve at the short end, and the projections for long-term rates dictate the changes at the long end of the curve. For instance, the recent rate hike at the Fed’s March meeting had varying impacts on the US Treasury yield curve. The short-term bonds (SHY), which are to the left side of the yield curve, reacted immediately to the announcement, but the long-term yields didn’t move by a similar percentage. The longer-term bonds, which are toward the right end of the yield curve, react to this interest rate hike and reflect investor expectations of economic growth, inflation (TIP), and risk appetite.

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Differing expectations for the future

The above graph shows the US Treasury yield curves from various time periods. Since December 2015, the Fed has embarked on a tightening cycle that has resulted in the short-term rates increasing from near zero to 1.68% in two-and-a-half years, but the long-term rates (TLT) remained anchored near the 3% rate. That’s due to the difference in expectations of the Fed and the markets.

Why is the yield curve flattening now?

The reason for the current flattening of the yield curve in this cycle is lower expectations for inflation (VTIP) growth. Although inflation growth has picked up in recent months, the markets seem to vary if the Fed continues its tightening program for an extended period, which would keep the long-term (TMV) yield grounded. That could be causing the yield curve to flatten. Let’s look a little closer at how inflation has impacted the yield curve.

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