Much Ado about Curve Flattening

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The Fed funds target rate and Treasury yields remain historically low, even though the Fed increased the target rate in December 2016.

There are so many strategists and media moguls talking about the flattening of the yield curve that I feel compelled to straighten a few things out. No one is worried about the 10-year UST yield minus the 2-year UST yield per se. What they are worried about is if these two points on the yield curve invert. When it inverts or goes negative, it is a powerful predictor of a recession. In January 2000, the 10-year was 6.61% and the 2-year was higher at 6.63% or inverted yield curve signaling the impending bear market. In January 2007, the 10-year was 4.99% and the 2-year was higher at 5.00% or inverted yield curve signaling the impending bear market - aka the “Great Recession.” So it is ominous, but “this time it’s different." I put that in quotes because that tends to be the death knell of an analyst not respecting history. Regardless, I am sticking to it because of all of the positives. First of all we went about eight years at zero Fed Funds rate and we are now getting “back to normal.” That is good news, very good news. The 2-year yield has moved up in concert with this market normalization, albeit slightly higher. The 10-year yield had been in a downward trajectory for a couple years from 3% at the end of 2013 to 1.36% in July 2016. This 1.36% - the lowest in history - was indicative disinflation, recession or even depression. That the 10-year yield is a robust 2.77% today is a signal that Armageddon is far, far away. Yields this high are indicative of GDP growth hovering at around 3%, which is higher than the previous Administration’s entire two-term presidency. In other words, focus on the level of interest rates more than whether the yield curve is flat. The outlook for growth has not been this good in over a decade. Please review slide 34 of the Global Perspectives book entitled - Fed Funds Target Rates and U.S. Treasury Yields.

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