Bond market activity returned to normal at the end of February after a wild ride early in the month. Changes in interest rates and credit spreads – the difference between quality and high-yielding bonds – were muted, and the decrease in volatility led to more new issues in the marketplace.
The yield on the two-year Treasury note rose 5 basis points or 0.05% to end the week at 2.24%, just below its highest level since September 2008. Meanwhile, longer-term bonds were barely changed: the five-year Treasury note decreased one basis point to 2.62% and the yield on the 10-year Treasury bond was unchanged at 2.87%. The yield on the 10-year bond traded within close to the 3% psychological barrier earlier in the week before retracing lower as investors took advantage of the higher yield and pushed it back down.
The spread between the yield on two-year and 10-year Treasury bonds had been on a long-term downward trend and was its lowest since before the 2008-09 global financial crisis. That trend was interrupted by the spike in volatility in early February, but now that volatility has subsided, the downward trend has resumed. At the end of last week, the spread declined to 63 basis points from as high as 78 basis points on February 9, but it is still above the low of 50 basis points reached in January.
Does the Yield Curve Suggest Trouble Ahead?
The yield curve – which marks the difference between short and long-term rates – has flattened as short-term rates have risen in conjunction with the increases in US interest rates as the Federal Reserve continues to normalise monetary policy. In the past, a flattening yield curve often indicated a weakening economy and in many cases portended a recession. This time around, it may not be foreshadowing a recession, as it is being heavily influenced by global central bank actions.
The outlook for economic expansion in the first quarter remains relatively strong. According to the Atlanta Fed's GDPNow model, the estimate for real GDP growth in the first quarter is 3.2%, and the consensus forecast for all of 2018 is 2.7%. The outlook for continued economic expansion appears likely as financial conditions in the United States remain highly accommodative.
Based on the Fed's statements and its own interest-rate forecasts, it appears that short-term rates may continue to head higher in 2018. According to the CME FedWatch Tool, the probability that the Fed will lift rates to 1.50%-1.75% after its March meeting held steady at 83% compared with the prior week. And the market expects further rate hikes through the rest of the year. The probability that the federal-funds rate at the end of 2018 will be greater than 1.75% is 91%, and the probability that it will be 2% or higher is 64%. According to the projections from the Fed's December 2017 meeting, the average interesr rate forecast of the board members is 2%, 2.70%, and 3% for the years ended 2018, 2019, and 2020.
Inflation expectations have risen thus far this year and are near the high end of their range of the past year. Currently, the market expectation for average inflation for five years, beginning five years from today, is 2.16%, only 10 basis points higher than where it ended 2017.
