Yield Curve Expected To Flatten

The latest difference between the 10-year bond yield and the 2 year bond yield is 58.44 basis points. That’s about 8 basis points of steepening from the bottom on January 4th. The CME website shows the next likely rate hike will be in March as there’s a 1.5% chance of a hike on January 31st which is the next meeting and there’s a 68.1% chance of at least one hike in March. The January meeting will be important to determine if the March meeting has a hike. The other important stat is the December CPI which will be released on Friday.

I talk a lot about the yield curve and the expectations for the Fed funds rate, but I never talk about the expectations for the yield curve. As you can see from the chart below, bond investors are the most positioned for a flattening in the yield curve than ever before. This doesn’t appear to be a trade you want to fade as the expectation for a flatter yield curve accurately predicted the flattening in 2017. The closer the yield curve gets to an inversion, the fewer investors will think the yield curve will flatten as there’s less room for it to go down. We’re not there yet because it looks like the Fed will raise rates throughout this year as the economy heats up. I expect the rate hike cycle to end in 2019. A lot depends on where the economy is, meaning how many rate hikes the Fed can get away with.

The crazy part of this situation is Yellen says this time is different as she’s not worried about the inversion which will likely occur in the next few quarters. The reason she’s saying the yield curve isn’t a big deal is because she thinks monetary policy isn’t restrictive like it was in previous inversions. That’s an odd statement. While I agree with Yellen that policy is still loose right now, we don’t know exactly what policy will be like when the yield curve inverts. By saying the inversion doesn’t matter, she’s disagreeing with the market about what it means to be restrictive. When the Fed disagrees with the market, the market usually wins.