Bond Traders Should Prepare for Yield Curve to Zero Out in 2018
(Bloomberg) -- Just how much further can the relentless flattening of the U.S. yield curve go? All the way to zero, according to T. Rowe Price Group.
The asset manager, which oversees about $948 billion, is the latest to weigh in on the trend that’s pushed Treasury curves to the flattest levels in a decade. The Federal Reserve has raised interest rates twice this year and is set for a third hike in December, leaving two-year notes at the highest yields since 2008. Meanwhile, demand from overseas investors, insurers and pension funds has kept 10-year yields near their 2017 average.
“The peak yield on the 10-year Treasury should roughly approximate where the final level of fed funds settles out, so that to us implies a flat yield curve if we assume the Fed will do two or three hikes in 2018,” Mark Vaselkiv, chief investment officer of fixed income at T. Rowe Price, said at a press briefing. In his eyes, the Fed will likely stay the course, and the difference between short- and long-term debt could reach zero as soon as the second half of next year.
Expectations are beginning to build for the Fed to step up its pace of rate hikes as inflation shows signs of stabilizing and with the lowest unemployment rate since 2000. Economists at Goldman Sachs Group Inc. and JPMorgan Chase & Co. are among those forecasting that the Federal Open Market Committee next year will likely tighten four times, rather than the three implied in policy makers’ projections.
If the committee does what Goldman and JPMorgan project, on top of a December move, the midpoint of the fed funds target rate would be 2.375 percent. That matches the 10-year Treasury yield, which ended Thursday at the same level. In other words, if the Fed can’t move the long end, officials will bring about a zeroing out of the yield curve.
“Once you get fed funds above 2 percent, you’re starting to get closer to the zone where you can talk about a flat yield curve,” said Steve Bartolini, a fixed-income portfolio manager at T. Rowe.
Some bank strategists aren’t so sure the Fed would willingly allow that to happen. Bank of America Corp. strategists say the flattening trend will prevent the Fed from raising rates as fast as officials may want.
The central bank wouldn’t risk “consciously putting short-term rates above five-year term rates,” Bank of America strategists led by Shyam Rajan said this week in a note. They’ve never allowed that to happen aside from a brief period in its previous tightening cycle, they wrote.
Lacy Hunt, chief economist at Hoisington Investment Management, said last month he sees the yield curve inverting by the end of next year as long as the Fed keeps shrinking its balance sheet. John Herrmann at MUFG Securities Americas wrote in a note this week that he’s targeting 2020 for the spread to hit zero.
The timing matters because an inverted yield curve has proven a reliable indicator of an impending recession. When the spread between short- and long-term debt shrinks, it tends to hurt bank earnings and the real economy.
The yield curve from two- to 10-year Treasuries is about 66 basis points, near the flattest since November 2007. The last time the spread was at that level and still getting narrower was April 2005, about two-and-a-half years before the recession began. It remained close to zero for about 18 months.
‘‘Within a 12-month horizon, it makes total sense that the curve typically flattens when the Fed hikes,’’ said Alan Levenson, T. Rowe’s chief U.S. economist.
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