Is The World Going Flat?

Shorter-term rates have moved higher, but the bumps in the overnight rate have had little impact past the two-year note.

In December 2015, the Federal Reserve raised short-term interest rates for the first time in seven years. The quarter-point increase bumped the target funds rate from 0.00-0.25% to a new target range of 0.25-0.50%. The Fed raised the target funds rate for the fourth time this past June, bringing the target rates up a full percentage point to 1.00-1.25%.

With that sort of increase, you might assume longer-term rates also are up. But you would be wrong.

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The yield on the 10-year note the day before the Fed tightened for that first time in 2015 was 2.27%. The rate on the 10-year note the day after the Fed tightened in June 2017 was 2.17%. Shorter-term rates, more sensitive to the overnight rate, have moved higher, but the impact wears off quickly past the two-year note.

Big bond accounts remain awash in money spewed out by central banks over the past few years, and they have leveraged that money and built a steady source of profits. They are not ready for that game to end. They justify keeping a lid on rates by pointing to recent weaker economic and inflation data as evidence all is not well. But above all else, they are counting on Washington to fail at producing meaningful tax reform and infrastructure spending.

I think the economy can still survive without tax reform, but I’m not one of those big bond managers.

Even Fed chair Janet Yellen was unable to convince bond managers that the economy was improving and inflation was on a temporary recess. A surprisingly upbeat Yellen took the podium in June to downplay recent weakness and emphasize a longer-term positive outlook.

The Fed currently expects to raise the funds rate one more time this year and three times next year. That would bring the fed funds rate to 2.00-2.25% by the end of 2018.

Surely the longer-end of the bond market could not withstand that magnitude of an increase.

Au contraire!

If the economy muddles along at 2.00% GDP growth, net of inflation for retail sales rise 2.00%, wages rise 2.00%, and inflation does not move higher than 2.00%, it’s conceivable bond accounts won’t budge. They can eke out leveraged gains by using bonds as collateral to obtain cheap financing, and they can maintain the view that the economy could tip over at any time.

A 2.00% funds rate and a 10-year note yield of 2.00% are not outside the realm of reason. A 2.00% world still has some fat in it. It’s not as weak as skim but not as rich as a whole economy.

Skiing down a steep mountain is fast, but cross-country skiing is a real slog. The same is true for the yield curve.

Managing the balance sheet with a steep yield curve is not always a breeze, but it affords a lot of choices to take advantage of the yield curve. Managing the balance sheet with a flat curve is much more challenging, especially in areas that have competitive deposit rates.

Over the next few months, we are likely to see much greater bond volatility. The ongoing Trump saga, the debt ceiling battle, and the progress or lack thereof on tax reform will be key factors for the bond market. But keep your focus where it belongs.

First and foremost, monitor job growth and wages in your local area. That matters more to members than anything out of Washington, D.C. Second, pay attention to inflation. If inflation rebounds, the long-term case for a flat yield curve becomes far less compelling.

But if the world goes flat, it won’t be the first time. The yield curve was flat for most of 2006 and 2007, late 1999 through midyear 2000, and for most of 1994 through 1997. Of course, nominal rates during those flat periods were roughly 5.00-6.00%,which afforded financial institutions some latitude, but the same challenges will apply to a 2.00% flat world.

If you weren’t around managing the balance sheet during those times, find someone who lived it. Spending some time during this upcoming planning season to strategize the what if world of 2.00% could pay big dividends.

Dwight Johnston is the chief economist of the California and Nevada Credit Union Leagues and president of Dwight Johnston Economics. He is the author of a popular commentary site and is a frequent speaker at credit union board planning sessions and industry conferences.

July 1, 2017

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