The Treasury yield curve attracts a great amount of attention because of the important information embedded within it. Its shape can provide a (blurry) window into the outlook of investors: where they expect future rates and inflation to be and how much compensation they demand for uncertainty. If we further decompose expectations for real interest rates, inflation, and risk premium, we can also begin to understand the consensus view for future monetary policy. To that end, investors have historically viewed an inverted yield curve (i.e. weaker growth and inflation in the future, expected looser monetary policy and therefore lower rates going forward) as a leading indicator of recession.
For a Treasury curve trader, a view on Fed policy is crucial because monetary policy is a major driver of yield curve volatility. While longer-term rates are stickier and anchored by slow moving expectations of equilibrium, short-term rates are much more volatile and consequently drive the largest changes in the shape of the curve.
Currently, there is a certain level of comfort within the market that the Fed will continue to gradually raise rates, and front-end yields will increase, causing the curve to flatten and eventually invert when policy gets tight enough to restrict future growth. For 2018, the market is pricing in two additional rate hikes (for a total of three), matching the number of rate hikes in 2017, while the Fed is forecasting another three in 2019.
Another important consideration for a curve traders are “forwards”. Forward interest rates are equivalent to an economic “breakeven” level for an investor. For example, the forward curve is calculated under the assumption that an investor should be indifferent between investing in a 10-year bond or instead one 5-year bond today and another 5-year bond in five years’ time. Today, the forward curve is quite flat. To achieve a positive return on a curve flattening trade, the actual treasury curve must flatten even more than the forwards imply. If the forward curve suggested that the 2s10s spread should flatten 15bps over a one year horizon, but in reality, it only flattened 10bps, it would have been better to own the 2-year part of the curve versus the 10-year bucket over the course of the year .
This tightening cycle has been unique, just as the easing cycle before it was considered “unconventional”. Consider the order in which the Fed employed its tools during the crisis. When the Fed eased policy, the FOMC started by lowering rates to zero and followed by expanding the balance sheet through QE to further lower long-term rates. On the way out, the Fed started first by raising rates, while keeping the balance sheet large, thus maintaining residual downward pressure on long-term yields. Short-end rates have risen as the Fed hiked 175bps since December 2015, and the curve has subsequently flattened. Only now in 2018 has the balance sheet run-down finally started to materialize with ~380bln of run-off expected in MBS and Treasuries by year-end.
Before we look at the outlook for 2018, let’s look back at three different phases within the current cycle to see what the forward curve implied versus what actually transpired.
Looking first at the curve in 2016, this was a period of set-backs for the Fed. After raising rates at the end of 2015 and officially starting the tightening cycle, they were put on hold when the dollar strengthened, equity market volatility rose, and fears of a China slowdown emerged. Not surprisingly, the Fed’s holding pattern caused the curve to flatten less than the forwards implied at the start of the year because the Fed was not able to raise short-rates again until the end of 2016.
The opposite occurred in 2017. Despite a softening in inflation mid-year, the reaction of the Treasury curve looked more like a traditional hiking cycle. The Fed was able to deliver more than the market had originally anticipated, and the curve flattened more than the forwards implied.
Finally, let’s look at 2013, when the Fed first attempted to step away from its maximum easing bias by slowing the pace of purchases in the QE3 program. The taper tantrum subsequently occurred and caused not only a re-set higher in front-end yields but long-end rates as well. The forwards implied a flattening but the curve instead steepened.
As we try to forecast 2018, there are many valid arguments for why we could have another year of traditional curve flattening similar to 2017. If US growth maintains its healthy pace and Fed policy moves incrementally more hawkish than what is already priced in, it stands to reason that yields on the front-end will rise more than those on the back. However, we are also closely watching four important risk factors that could cause a re-set in the long-end of the yield curve as well.
In conclusion, while we are not anticipating a large or disruptive move higher in long-end rates, we do think it’s important to keep in mind the growing number of risk factors that might impede further yield curve flattening versus the forwards.
 This is a simple example assuming we are looking at the analysis on a constant maturity basis