Thoughts on Interest Rates and the Yield Curve


James Bernard, CFA, Managing Director, Fixed Income

Over the last six months intermediate term U.S. government bond yields increased just over 100 basis points, and year to date they have increased over 40 basis points. The actual yield curve remains relatively flat with 2 to 10-year yields differing by only 64 basis points. Historically, 10-year Treasury yields average about 100 basis points higher than 2-year Treasury yields. Continued low inflation numbers are a major reason longer term interest rates remain very low. Additionally, a very accommodating FED monetary policy has contributed to lower rates in recent years.

Going forward the primary questions surrounding interest rates are as follows. Will this recent movement higher continue? Will historically low credit spreads continue? How will worldwide interest rates and central bank policies around the world influence our interest rates in the next few years?

Yield Curves

Yield Curve
Source: Bloomberg, March 5, 2018

As the above yield curve illustrates, not only are yield curves relatively flat (as discussed above), but U.S. rates remain significantly higher than Euro sovereign bond yields. A more accommodating central bank policy in the Eurozone and Japan and economic growth that, in general, trails the U.S. recovery this cycle, accounts for lower rates overseas. Because of these historically low rates overseas and significant demand for yield, 5-year maturity high yield Euro bonds are currently trading at 3.00%, or just 35 basis points above the 5-year U.S. Treasury note. This means that high yield Euro corporate notes trade at lower yields than High Grade U.S. Corporate bonds, which obviously seems irrational.

We believe going forward this unusual pattern of U.S. rates versus Euro rates will serve to somewhat keep a lid on how high U.S. rates will go over the next few years. While we still expect three or more rate increases by the FED over the next year or so, and the potential for some credit widening associated with the FED balance sheet reduction program, we do not believe rates will take off on the upside for reasons discussed above. All of this assumes that inflationary pressures remain low for the foreseeable future. We believe a modestly steeper yield curve is likely since a little inflationary pressure may appear this year.

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