Another Rate Hike Approaches As The Yield Curve Flattens

The Federal Reserve is widely expected to raise interest rates again in June, a policy decision that looks set to further squeeze the Treasury yield curve. The spread between the 10-year and 3-month yield is already the smallest since last October and another rate hike could cut the difference even more.

Analyzing the implications of a flatter curve has been topical lately, although there’s no sign of a consensus at the moment. CNBC offers a sample of the debate:

As Peter Boockvar of The Lindsey Group sees it, the spread is telling a story about both what traders think the Federal Reserve will do, and how they think the economy is likely to respond to those actions. As he alludes to, short-term bonds tend to be guided closely by expectations of Fed policy, while longer-term yields more purely reflect economic expectations.

When it comes to the falling spread, “It’s becoming clear the reasoning and that is a Fed that is intent on raising short rates due to their statistical employment and inflation hurdles having been met (and thus backward looking viewpoints) and market worries about how the economy will handle that reflected in the drop in long rates,” Boockvar wrote in a Monday note.

Oppenheimer’s Ari Wald, however, doesn’t see trouble on the near-term horizon.

We don’t think the flatter curve is a warning,” he said. “As long as banks can borrow short[-term debt] and lend long[-term debt], we think the economy can do just fine and the stock market can do just fine. In fact, the level and direction of the yield curve now looks a lot like it did in 1994 and it looks a lot like it did in 2004 — years where you still wanted to be invested in stocks.

An inverted curve would be worrisome, signaling elevated risk of recession. But the economic data continue to point to a low probability that a new downturn is near, based on the numbers published to date.

The question is whether the yield curve will continue to tighten? The answer will depend on whether the Fed continues to tighten and how the Treasury market reacts on the longer end of the curve.