Market Extra: Here’s how the Fed is flattening the yield curve

Traders betting on a steeper yield curve are being thwarted by two factors: a Federal Reserve intent on raising rates and lackluster inflation. This potent combination is making for the flattest yield curve by one measure in nearly a decade.

The yield curve is a line plotting the yields across Treasury maturities from the shortest dated to the longest, and can reflect investor expectations for growth and inflation. A flatter curve is seen as a sign investors are worried about growth.

See: Should investors still worry if the yield curve sends this ominous signal?

After four rate increases in the current hiking cycle, the spread between the 5-year yield
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  and the 30-year yield
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  one way to assess the curve’s steepness, narrowed to 0.86 percentage point. The curve has flattened steadily since Donald Trump’s presidential election victory last November sparked a selloff in long-dated Treasurys on fears that his pro-growth agenda would spur inflation. Yields and bond prices move in opposite directions.

The dramatic speed of the flattening has surprised investors. In the past four tightening cycles, the gap between the 5-year yield and the 30-year yield narrowed on average by 0.98 percentage point. But after peaking at 3.02 percentage points in November 2010, the spread has tightened by 2.18 percentage points.

“There is a sense that the market is getting ahead of itself in the aggressiveness of the flattening currently underway,” wrote Ian Lyngen and Aaron Kohli, fixed-income strategists at BMO Capital Markets.

Read: Investors fear a Fed policy misstep as central bank reaffirms rate-hike trajectory

Traders tend to concentrate on the spread between the 5-year yield and the 30-year yield versus other measures of the curve. The 5-year yield can serve as a more accurate reflection of market expectations for short-term rates than the 2-year yield
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 , which is largely under the central bank’s control, said Tim Alt, director of currencies and rates at Aviva Investors.

At the long end of the curve, the 30-year yield has slipped as inflation expectations weaken. Investors demand more of a yield premium when they fear inflation is on the rise because inflation erodes the purchasing power of future cash flows.

“It is the lack of inflation and anemic term premium that are exaggerating the move,” wrote Lyngen and Kohli. The term premium refers to the extra yield investors need to be compensated for buying a long-dated bond if short-term yields do not develop as expected.

The narrowing term premium reflects the newfound transparency of the Federal Reserve under Chairwoman Janet Yellen and former chairman Ben Bernanke, said Marvin Loh, senior fixed-income strategist at BNY Mellon.

Since the Fed’s September policy meeting, investors have been inundated with speeches from central bankers. Every voting member of the Fed’s interest-rate setting body has delivered public remarks, many more than once, giving market participants a clear idea of the central bank’s plans, as well as factors that could forestall the current tightening path.

On the flip side, the central bank’s push to telegraph its intentions have also helped power short-dated yields
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  to their highest level since the recession. Dallas Fed President Robert Kaplan highlighted this trend, saying the central bank should raise rates one more time this year on Tuesday. The Federal Reserve has signaled further rate rises on the assumption that tightness in labor markets will spur wage growth and, in turn, inflation.

But inflation has been absent in recent months. The Fed’s preferred inflation measure, known as the personal consumption expenditures deflator, was 1.43% year-over-year in August, a steady descent from the five-year high of 2.18% notched in February.

Nonetheless, Yellen has tried to get ahead of the curve, adding to investors’ concerns that a lack of price pressures will not put off the central bank’s plan to see interest rates move higher.

Also read: Fed flunks econ 101: understanding inflation