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The Flattening Yield Curve: We're Not Too Worried
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The Flattening Yield Curve: We're Not Too Worried
The U.S. yield curve has been flattening and that has generated concern from many investors because flattening curves have been associated with a signal prelude to a recession. While historically one can draw this parallel, we think it is always important to understand why the curve is flattening, to interpret better the signal it may be sending.
Why is the yield curve flattening?
The yield curve is flattening because the U.S. Federal Reserve (Fed) has been increasing front end policy rates since December 2015. The rise in front end policy rates has occurred during a period when inflation has been low and below the 2% target as measured by core personal consumption expenditures (PCE). Only recently has inflation risen to target levels. The combination of rising policy rates during a period of low and contained inflation is a natural impetus for a flatter curve. Said differently, under these described conditions, the path of least resistance is for a flatter curve.
What differences should we consider today about the curve flattening versus history?
FED IS INCREASING RATES, NOT TIGHTENING POLICY.
This is an important distinction, because a tightening policy is designed to slow down growth and it is a very common tactic for the Fed to overshoot tightening and slow the economy more aggressively as an insurance policy to thwart inflation.
FED HAS NOT INDICATED IT WILL TIGHTEN POLICY ANYTIME SOON.
Currently, the Fed’s objective is to move to a neutral policy rate, not restrictive, as long as inflation does not materially rise above 2%, which thus far is not a concern. Inflation has remained very subdued, throughout the post-09 economic recovery, even as the labor market has tightened and estimates of economic slack have reduced.
UNUSUALLY SHORT AND SMALL RATE HIKE CYCLE.
Current expectations of the market and the Fed are that short term interest rates are not expected to rise much after the next 18 months. This would make the current hiking cycle a very unusual one. First, the Fed has raised rates on average three times a year, which is a lot slower than recent interest rate cycles, where 8 rate hikes a year was normal.1
Second, if the cycle ends when currently priced, it would have been a far smaller one than usual, with the federal funds rate only increasing 200 basis points (bps), vs. 425 bps in 2004-06, and 300 bps in 1994-95.2
MONETARY POLICY HAS KEPT TERM PREMIA3 VERY LOW.
Quantitative easing (QE) was designed to depress the term premia of the yield curve and that has the effect of reducing long-term interest to much lower levels than they otherwise would be. Based on calculations from our term premia model, term premia has averaged about -22 bps since the global financial crisis versus a pre-crisis average of about +25 bps. This means the yield curve is about 47 bps flatter than ordinary if we adjust for the technical factors related to the impact QE had on term premia.
What signal is today’s flattening yield curve sending?
We can draw a few conclusions about the current yield curve flattening, the main one being that it sends a weaker predictive signal about the future state of the U.S. economy than it has in the past. It’s not different this cycle and we believe the yield curve still remains a good measure of the relationship between how monetary policy actions that influence the short end of the curve are impacting future expected growth and inflation dynamics that influence the long end of the curve. While we care about the flattening yield curve, we’re not worried about an impending recession as we believe that today the slope of the yield curve sends a weaker signal and it would therefore take more flattening than ordinary to have the same impact on future growth than it had in the past.
RISK CONSIDERATIONS
There is no assurance that a Portfolio will achieve its investment objective. Portfolios are subject to market risk, which is the possibility that the market values of securities owned by the Portfolio will decline and may therefore be less than what you paid for them. Accordingly, you can lose money investing in this Portfolio. Please be aware that this Portfolio may be subject to certain additional risks.
Fixed income securities are subject to the ability of an issuer to make timely principal and interest payments (credit risk), changes in interest rates (interest-rate risk), the creditworthiness of the issuer and general market liquidity (market risk). In the current rising interest-rate environment, bond prices may fall and may result in periods of volatility and increased portfolio redemptions. Longer-term securities may be more sensitive to interest rate changes. In a declining interest-rate environment, the portfolio may generate less income. Mortgage- and asset-backed securities are sensitive to early prepayment risk and a higher risk of default and may be hard to value and difficult to sell (liquidity risk). They are also subject to credit, market and interest rate risks. Certain U.S. government securities purchased by the Strategy, such as those issued by Fannie Mae and Freddie Mac, are not backed by the full faith and credit of the U.S. It is possible that these issuers will not have the funds to meet their payment obligations in the future. High-yield securities (“junk bonds”) are lower-rated securities that may have a higher degree of credit and liquidity risk. Public bank loans are subject to liquidity risk and the credit risks of lower-rated securities. Foreign securities are subject to currency, political, economic and market risks. The risks of investing in emerging market countries are greater than risks associated with investments in foreign developed countries. Sovereign debt securities are subject to default risk. Derivative instruments may disproportionately increase losses and have a significant impact on performance. They also may be subject to counterparty, liquidity, valuation, correlation and market risks. Restricted and illiquid securities may be more difficult to sell and value than publicly traded securities (liquidity risk).
Please consider the investment objective, risks, charges and expenses of the fund carefully before investing. The prospectus contains this and other information about the fund. To obtain a prospectus, download one at morganstanley.com/im or call 1-800-548-7786. Please read the prospectus carefully before investing.