What Does Curve Flattening Imply for Fed Policy?

Apr 18, 2018

Yesterday’s action in Treasuries, while modest in basis point moves, was telling on a few other fronts. First, we saw a couple of solid economic releases in March Housing Starts, and Industrial Production but yields barely rose on that morning news. In fact, the curve continued to flatten to the lowest level in ten years.  Second, the latest flattening was driven by long-end yields dropping, even in the face of decent economic releases. That tells you investors believe the Fed will keep raising rates to stay ahead of inflation risks, and perhaps checking growth at the same time.  Third, the curve flattening took place alongside equities rallying over 200 Dow points and oil finding a continued strong bid. That gives you more hints of how strong the Treasury action was even with modest changes in yields.   Despite economic gains and risk-on trades, fixed income investors believe the Fed will continue to hike rates, limit excessive growth and squash inflation threats long before becoming serious. Add in a seasonal bias to lower yields in the spring and summer months and curve flattening seems likely to continue with short-end yields moving higher with Fed rate hiking expectations and long-end yields remaining, more or less, range bound.


  Economic News


With corporate earnings season fully upon us, the impact of the tax cut legislation is clearly being shown. The largest Wall Street banks are reporting windfall profits in their first-quarter earnings, with many well beyond analysts' projections. Bank of America was the latest to beat expectations, on Monday reporting a 30% percent jump in its first-quarter profit over the same period last year. The bank chalked up slightly less than a third of that gain to a $500 million drop in its income taxes. Other Wall Street banks reported similar results Friday: JPMorgan Chase, Citigroup and Wells Fargo together saved $1.6 billion last quarter thanks to the new tax law’s 40% reduction in the corporate rate. The return of stock market volatility during the quarter also boosted revenue for trading desks. The corporate rate cut is but one of the ways the administration is aiding industry profits. Even more help is on the way for banks' as deregulatory moves get approved. The Senate-passed Dodd-Frank reform bill has stalled in the House where Republicans there want more expansive deregulatory action; the message, however, is slowly getting through to House members that any changes to the Senate bill will imperil the whole effort so expect movement on it very soon. 


While the tax cuts are boosting profits for banks and other corporate taxpayers, it is leaving a hole in the fiscal budget. By 2022, the U.S. government is projected to spend almost as much money on interest as it will on the military, more than $600 billion every year. The increasing interest expense underscores a new reality in Washington. In the old days, economic expansions were often used to narrow deficits or even generate brief surpluses. The new model has broken from that with deficits expected to grow over $1 trillion by 2020, even with an economy operating on all cylinders. That’s a concern for another day but a concern nonetheless.


Earlier this week, the president nominated two more people to serve as governors on the Federal Reserve. Richard Clarida, a Columbia University economics professor and longtime adviser to one PIMCO, is tabbed to be vice chairman filling the vacancy left by Stanley Fischer. Clarida is likely to be more of a policy centrist but certainly one who is comfortable in the present tightening campaign. The president also nominated Michelle Bowman, the current bank commissioner in Kansas, to fill another board vacancy. She is Trump’s first female choice for the Fed out of the five people he’s nominated and she is expected to bring with her a community bank perspective.


On the deregulatory front, the Fed is considering allowing banks a chance to comment on stress tests before they take them and dropping any qualitative review for the largest banks’ performance, according to Randal Quarles, the central bank’s vice chairman for banking supervision in his first testimony before the House Financial Services Committee. The supervisory role was created by the Dodd-Frank Act but went unfilled during the Obama administration.


Speaking of regulations, yesterday they invited comments on a possible change to regulatory capital standards in regards to the upcoming adoption of the Current Expected Credit Losses (CECL) standard. Specifically, the proposal would revise the agencies’ regulatory capital rules to identify which credit loss allowances under the new accounting standard are eligible for inclusion in regulatory capital and to provide banks a three-year phase-in option of the day-one adverse effects on regulatory capital that may result from the adoption of the new accounting standard.


In addition, the agencies are proposing to make amendments to their stress testing regulations so that banks that have adopted ASU 2016-13 (CECL) would not include the effect of it on their provisioning for purposes of stress testing until the 2020 stress test cycle. Finally, the agencies are proposing to make conforming amendments to their other regulations that reference credit loss allowances. The full proposal can be found here.




Market Update  Yield Curve Flattening Continues


We’ve been on about the flattening yield curve for awhile and now it’s reached levels not seen in 10 years. Now New York Fed  President-elect John Williams has joined the chorus. He said in a speech yesterday that inverted yield curves are a strong recession signal. If the long-end remains resistant to rising much above 3%, the Fed is probably closer to normalized policy than some may have imagined not long ago. The 2-10’s spread is currently 43bps implying two to three more hikes could put us near or through inverted territory. If more flat curve concerns spread to other Fed officials it may signal a new constraint to the ongoing tightening campaign. Keep an eye on those comments.

Flattening Yield Curve



Agency Indications Agency Indications — FNMA / FHLMC Callable Rates


Agency Indications — FNMA / FHLMC Callable Rates



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