Financial markets have pondered and predicted the Federal Reserve’s next rate increase for more than two years. How could it possibly surprise? Possibly through a different impact on the U.S. bond yield curve than many investors currently expect.
Typically when the Fed tightens, the yield curve flattens for a variety of reasons. The main driver is probably that a rate rise influences near-term rate expectations more than long-term expectations – in other words, a Fed hike typically means that interest rates may be higher over the next couple of years but not necessarily over the longer term. This is because investors often adjust their expectations for longer-term growth and inflation in the belief that higher rates will slow the economy and reduce price pressures.
When the Fed begins the next rate-hike cycle, which we expect this month, the yield curve will likely flatten between two-year and 10-year bond maturities as shorter-term interest rates react more to the rate hike than long-term rates. However, we don’t expect the long end of the yield curve – between 10-year and 30-year maturities – to flatten all that much because long-term inflation expectations are unlikely to fall from their already low levels.
Why? One unique aspect of the current interest-rate cycle is that the Fed is not aiming to slam the brakes on the economy or bring inflation back under control. In fact, the Fed would like to extend the economic expansion and see wages and prices rise a bit faster than they have in recent years. So even though we expect the Fed to raise rates faster than implied by the front end of the curve, these goals mean it is unlikely to raise them as far as many expect.
While the central bank is aiming to gently put short-term rates back on a path to neutral, a level of equilibrium for the economy, that rate is likely to be closer to 2% than 4%. The Fed may also tolerate inflation above its 2% target for some period of time as it seeks to reflate the economy. As a result, in a change from the historical pattern, the coming rate hike cycle may be accompanied by rising inflation expectations and significantly less yield curve flattening at the long end.