Yield Curve Analysis

The onset of the pandemic caused yields to plummet across the board and forced the Federal Reserve to intervene in financial markets once again. The federal funds rate was dropped to the zero bound and asset purchases were ramped up to stabilize the financial system from such an extreme shock to the global economy.

The economic outlook has changed drastically over the past 14 months, and thus the yield curve is also in a very different position. With growth projections and inflation expectations rising, the tail end of the yield curve has lifted off the ground – to near pre-pandemic levels in some cases. However, the Federal Reserve is still holding short-term rates near zero.

Long-Term Yields Rising Quickly

The economy is in a much better place than it was just 6 months ago. Projections from the Federal Reserve for GDP, unemployment, and inflation have noticeably improved since December. The labor market has added over 1.5 million jobs over the past three months and the employment-population ratio is up 0.5 percentage points since December, with much room for growth.

Consumer confidence has also increased drastically over the past couple months, notably in consumers’ assessment of the current situation. Vaccination rates and the relaxing of safety precautions around the nation has been liberating for many Americans.

Inflationary pressures are also building throughout the economy. After months of staying relatively muted compared to the speed of the recovery, the Consumer Price Index for April grew 4.2% from one year ago, the highest year-over-year growth since 2008. Along with inflation and growth expectations, 10-year yields have been rising steadily since August, but at an increasing rate since the holidays. Although leveling off recently, these yields are near pre-pandemic levels, and 30-year yields are at their highest level since November of 2019.

Fed Holds Steady on Short-Term Rates

Although economic activity has been accelerating rather quickly as of late, there are still some signs of weakness that policymakers are monitoring. The most recent jobs report was seen as a disappointment, with just 266,000 jobs added versus the expectations of nearly one million and the addition of over 770,000 in March.

Also, reading too much into one month of inflationary figures can misconstrue actual inflationary pressures. Prices in April 2020 were plummeting, and crude oil was at one point trading at negative $37 per barrel. Gas prices have rebounded from the unconventional lows of the recession because American’s are no longer stuck at home and can travel again. This normalization of prices is healthy for the economy, but if these pressures continue to build, then intervention by policymakers is likely.

Interest Rate Expectations for the Future

Even with the recent higher-than-expected inflation readings, Wall Street is still betting that the federal funds rate will stay near zero for at least the next few months. This also follows projections supplied by the Federal Reserve, estimating that overnight rates will stay near zero through 2023.

Along with keeping the policy rate near zero, the Federal Reserve is expected to suppress short-term treasury yields by continuing to purchase large amounts of these securities each month. These will continue “until substantial further progress has been made toward the Committee’s maximum employment and price stability goals.”

The Fed has become tolerant of some inflation readings above the 2% average target to make up for periods of low inflation, like during the pandemic. Employment has been placed as the primary half of the dual mandate for the time being. Unless inflation continues to climb at considerably high rates, look to the labor market for signs that the federal reserve is going to let go of short-term treasury yields.

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