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Why Rising Inflation Failed to Raise Long-Term Yields

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Interest rates and inflation

The primary reason cited by the FOMC (Federal Open Market Committee) for holding off on interest rate hikes since 2016 was lagging inflation growth. Whenever the Fed signaled rate hikes, the yield curve flattened since investors were not convinced that inflation (TIP) growth would pick up the pace, which would limit the Fed’s ability to raise rates. The Fed has set a target of 2% inflation (VTIP) growth, at which point the economy is expected to be running at a normal pace. At its recent March meeting, Fed members turned confident that inflation would hit the target in the coming months, increasing the odds for a fourth rate hike in 2018.

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A closer look at recent inflation numbers

The US CPI (Consumer Price Index) decreased 0.1% in March. But excluding the volatile food and energy prices, core inflation (SCHP) grew at an impressive rate of 2.1%, which was above the Fed’s 2% target. The increase, which followed strong growth for the Producer Price Index in March, could translate to higher inflation in the coming months. But the question that’s baffling everyone is why the yield curve is flattening when all economic data are painting a positive picture.

Other factors dominating yields

In recent weeks, volatility (VXX) in the financial markets has increased since uncertainty about possible trade wars, tensions in Syria, and President Trump’s personal legal issues have dominated the markets. In times like this, funds tend to seek refuge in safe havens such as bonds to protect capital, which has limited the rise of yields at the longer end (TLT) of the curve.

In the next part of this series, we’ll look at comments by James Bullard, president of the Federal Reserve Bank of St. Louis, who said the US yield curve could invert by the end of 2018.

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