Sunday, 18 of February of 2018

Economics. Explained.  

Treasury Notes — 10-Year Maturity

January 4, 2018

The yield on the 10-year note backed up dramatically following the election in November of last year as market participants feared that Trump’s tax cuts and the repatriation of funds currently held overseas could push the inflation rate  higher and force the Fed to tighten more quickly than it currently anticipates.   The rate rose from 1.7% right before the election to 2.6%.  It has since fallen back to 2,4%

The question arises, what is an appropriate level for the 10-year note?   The answer to that question lies in something called the “yield curve” which is nothing more than the difference between long-term interest rate and short rates.  Today the 10-year note is 2.4%, the funds rate (an overnight rate) is 1.25%, so the difference between long rates and short rates, or the yield curve, is 1.15%.  Historically, the yield curve has averaged 1.65%.  However,  the steepness of the curve varies depending upon whether the Fed is tightening or easing.

When the Fed tightens it raises short-term rates (i.e., the funds rate) much more rapidly than long-term interest rates rise, the yield curve “flattens” and can even invert.  When it inverts it means that short rates are higher than long rates, and the spread is negative.  Frequently an inverted yield curve can be a sign that the Fed has raised rates high enough that a recession might not be too far down the road.   You can easily see how the curve flattens, and even inverts when the Fed is in tightening mode.  That is not the case today nor will it be the case for several more years.

When the Fed eases they lower short rates (the funds rate) much more quickly than long-term interest rates decline and the yield curve “steepens”.  The steepening of the curve when the Fed is in aggressive easing mode can be seen easily.

The curve is not actually “tightening” right now, but it is trying to be less easy than it was previously.  The funds rate has climbed from 0.0% to 1.25%.  In  that period of time the yield on the 10-year note has fallen from 2.6% to 2.4%.  Thus, the yield curve has flattened from 2.6% (2.5% – 0.0%) to 1.15% (2.4% – 1.25%).

Between now and yearend the Fed should raise the funds rate from 1.25% to 2.0%.  At the same time the core inflation rate should climb from 1.7% today to 2.2%.  This combination of events should raise the yield on the 10-year note to 2.9% by the end of the year. Thus, the yield curve should flatten a bit further from 1.15% today to 0.9% (2.9% – 2.0%).  It does not appear to be in any danger of inverting between now and the end of 2018.  Thus, there is no danger of the economy slipping into recession between now and then.

Stephen Slifer


Charleston, SC

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