Home etftrends.com Three Ways the Yield Curve May Normalize

Three Ways the Yield Curve May Normalize

July will mark the second anniversary of the longest yield curve inversion in U.S. history, which is an anomaly when the yield on short-term Treasuries rises above the yields on longer-term. Higher short-term interest rates have been the catalyst for a large amount of assets flowing into short-term money market funds and Treasury Bills. Additionally, bond investors are currently in a difficult position as they attempt to play off the U.S. Federal Reserve’s (Fed) shifting dot plot and mixed macroeconomic data. This presents the question of when will the yield curve normalize and what does the path back look like?

As we have discussed previously, the record levels of stimulus from COVID relief led to a surge in the money supply. Consumers have also benefited from healthier balance sheets prior to COVID and record low mortgage rates that left households with more flexibility to keep spending. Jobs also helped fuel continued consumer spending despite rising prices resulting from inflation numbers not seen in decades. The economy has been resistant to this point, though we are starting to see inflation cool, the money supply decline, and slower consumer spending. The Fed is on the sidelines at this point but has indicated a readiness to ease in the event of a slowdown or consistent data indicating one is on the way. However, inflation still remains above the Fed’s 2% target and the roughly 2.3% the bond market has priced in as indicated by Treasury Inflation Protected Securities (TIPS) breakeven rates. In summary, economic indicators have been waning and this could put us closer to the beginning of a yield curve normalization.

In our opinion, there are a few plausible paths back to a normal yield curve. Our most likely scenario is that inflation falls slowly in fits and starts while economic data continues to soften, potentially into a shallow recession that prompts the Fed to ease. This would eventually bring short-term rates down at a muted pace as the Fed should be reluctant to reduce short-term interest rates quickly. With longer-term rates close to fairly priced, we would expect long rates to anchor near current levels, as illustrated below.

A less likely path to yield curve normalization would be for long-term interest rates to move significantly higher while short-term interest rates hold close to current levels. A move like this might be the result of a much stronger increase in inflationary pressure and/or the bond market repricing long-term Treasury yields in light of persistently high federal government deficits driving more bond issuance.

Scenario B

The least likely scenario is that the economy goes beyond softening and into a deep recession, which causes more aggressive cuts from the Fed. This outcome could result in some interest rate volatility that eventually leads to lower interest rates across the curve.

Scenario C

Regardless, a normalizing yield curve will likely not favor investors sitting on the sidelines in money market funds and equivalents, such as certificates of deposit (CDs) or Treasury Bills. A more accommodative Fed is usually a positive for equities and those investors who locked in higher rates when they had the opportunity to do so.

We have moved our fixed income allocations to focus on the belly of the curve, close to a 5-year duration. We think the belly of the curve is the sweet spot that offers the benefit of high current yield while also providing some protection from a few of the most pressing risks. For example, this intermediate range of the curve has the benefit of locking in the higher rate environment without being at full risk in case long-term bonds sell off on an upside surprise to inflation or federal deficits. This sweet spot also protects from the risk of Fed interest rate cuts reducing yields in the short end of the curve.

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