Since the first of the year, the term structure of interest rates in the United States has been falling.
Investors have been waiting for this drop for some time now.
Short-term interest rates have risen.
The Federal Reserve will start raising its key interest rate at its next Federal Open Market Committee meeting on March 15-16.
And, the Federal Reserve is expected to continue this year with further increases in its key rate, although experts believe that due to economic problems resulting from the Russian invasion of Ukraine, there will not be as many increases. increases than initially thought.
As the Federal Reserve tightens on the currency and short-term interest rates begin to rise, the term structure of interest rates generally flattens and may then turn negative.
We are only in the early stages, so we will have to follow the current situation through its various stages.
At the beginning of the year
In January, the Federal Reserve actually made the promised reduction in the amount of monthly purchases it was making.
The plan was to reduce its purchases until March and once the reduction was over, it would start raising its key interest rate.
On January 3, 2022, the Standard & Poor’s 500 stock index reached its last all-time high. The stock market has been falling ever since.
On January 3, 2022, the difference between the yield on the 10-year US Treasury note and the yield on the 2-year US Treasury note was 86 basis points, or 0.86%.
On March 7, the difference between the two yields was 24 basis points, or 0.24%. The difference therefore decreased by about 74%.
We can see this drop in the slope of the yield curve in the following graph.
The spread between the yield of the 10-year US Treasury note and that of the 2-year US Treasury note has not been this low for a very long time, on March 6, 2020, in fact.
And, at that time, the yield gap was increasing rather than decreasing.
So, theoretically, we are heading towards a tipping point in the economy.
In the past, the short-term end of the market rises and rises relative to the longer-term end of the market. Generally, once this happens, an economic recession occurs.
This is what happened in March 2020. The Covid-19 recession is short-lived and only lasts until March and April 2020.
Regardless, the yield curve had risen and once the recession hit, the yield curve started to turn much more positive.
The thing is, we don’t really seem to be in recession territory.
Inflation is reaching uncomfortable heights. Unemployment still seems to be falling. And the economy seems to be doing well.
Either way, it looks like the yield curve will flatten and could even turn negative if the Federal Reserve raises its key interest rate further.
What is happening?
Well, let’s look at the composition of the 10-year yield.
We often decompose the yield on government securities into one component that we call the expected real interest rate and another component that we call the expected rate of inflation.
Doing this at the present time gives us the expected real interest rate, which is now negative 1.03%, and an expected inflation rate of 2.81%.
Starting first from the expected inflation rate, we notice that the expected inflation rate has not been this high for a long time. Real inflation was low during the economic recovery from the Great Recession, which ended in June 2009.
Investors simply don’t expect high inflation, even though recent numbers have risen around an annual rate of around 6.0%.
But, given an expected inflation rate of 2.81%, we consider the expected real interest rate to be negative, in fact, a negative rate of 1.03%.
What is happening here?
Well, over the past few years, I’ve argued that the expected break-even interest rate has moved into negative numbers due to foreign funds coming into the United States. I’ve talked about it in several posts in the past.
In the current situation, we can show that the expected real interest rate has come down a lot since the Russian invasion of Ukraine.
In fact, the expected real rate fell from around minus 50 basis points just before the invasion and is now around minus 100 basis points.
In other words, enough money has flowed into the United States since the invasion began to cause the expected interest rate to drop by 100%.
It’s a very unusual event, but these are very unusual times.
And that’s what the Fed is up against
Investors expect the Federal Reserve to raise its key interest rate this year to fight inflation.
However, the Fed is going to have to deal with risk-averse flows of money entering the United States from elsewhere in the world.
In other words, it looks like the Fed is going to try to tighten the liquidity floating around in the financial markets, excess liquidity that has come from its own actions over the past two years, it’s also going to have to fight all this new flow of funds risk averse, coming to the United States from elsewhere in the world.
The task is not getting any easier for the Fed.
I think, given these circumstances, it would be a good idea for investors to keep an eye on the term structure of interest rates as the Fed tightens and raises its key interest rate.
A lot is going to happen in this market and a conscious investor needs to understand what is happening in this space.