June 5, 2018


The term structure of interest rates flattened in May, as the U.S. dollar strengthened and political stress in Europe escalated.  The benchmark U.S. 10-year Treasury yield reached a seven year high of 3.13% before declining to end the month at 2.86% (Exhibit 1).


U.S. Treasury Yield Curve

 Source: Bloomberg


Widening interest rate differentials between U.S. Treasury securities and European sovereign debt (the yield differential between the 10-year U.S. Treasury and German Bund reached a record high of 258 basis points on May 28th (Exhibit 2)), combined with tightening monetary policy from the Federal Reserve (Fed) caused the U.S. Dollar Index to appreciate 2.3% in May.  A stronger U.S. dollar led to commodity prices and inflation expectations declining during the month (West Texas Intermediate crude oil futures contracts returned negative 2.1% and the 10-year inflation breakeven rate decreased by 9 basis points).  Additionally, U.S. dollar strength has started to create financial stress for highly indebted emerging market countries, in particular Turkey and Argentina.


U.S German Yield Spread

    Source: Bloomberg


Political stress in Europe has caused investors to reassess their forecasts of the number of Fed rate hikes likely to occur in 2018.  The instability of the Italian government and the rise of an anti-euro populist party caused the Italian 2-year rate to spike nearly 230 basis points in a two day period in late May.  Investor demand for safe haven assets increased over the same period as the 10-year U.S. Treasury and German Bund rates declined 15 basis points.  A rate hike in June is widely expected, but investors now see just a 30% probability that the Fed will raise interest rates three additional times this year, down from 50% a few weeks ago (Exhibit 3).


Number of Rate Hikes Market Expects in 2018

             Source: Bloomberg


We forecasted a flattening yield curve earlier this year, and now the yield curve is the flattest it’s been since 2007.  Fed policymakers are showing growing concerns regarding this flattening, and communicated that they would be content to let inflation briefly run above their 2% target.  The Fed has promised two additional rate hikes this year, but does not want to make a policy mistake resulting in an inverted yield curve and, possibly, a recession.  Fed board members are eager to continue the ‘normalization’ of interest rate policy, while various risks to economic growth (the evolution of trade policy not least among them), certainly weigh on their minds.


We forecast that the U.S. Treasury yield curve will continue to flatten, with the short end of the curve rising as the Federal Reserve continues to raise the federal funds rate, and the long end declining modestly.  The elevated yields currently available to fixed income investors supports our strategy of maintaining durations slightly longer than those of corresponding benchmarks.


Justin Packard




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