Sunday, April 13, 2014

Rising Interest Rates and a Flattening Yield Curve

What exactly tends to happen when the Fed tightens (raises interest rates)?

Historically, the yield curve flattens, meaning the difference between short term interest rates and longer term interest rates becomes less, when the Fed tightens. For example, currently, the 5 year Treasury to 30 year Treasure curve is 190 basis points (the 5 year is 1.58% and the 30 year is 3.48%). A flattening means that difference may go from 190 basis point to 150 basis points. But which bond will change? If the 30 year went to 3.08%, and 5s stayed at 1.58%, we'd have our 150 basis point steepness as a result of a bullish flattening. If, instead, 5s went from 1.58% to 1.98%, we'd also have a 150 basis point difference, but it would be the result of a bear flattening.

According to some recent research by BMO Harris, the market appears to be heading for a convergence point in interest rates below 3.75%. In other words, the long bond may fade 20 to 25 basis points, but most of the flattening will come from bear flattening on the short end.

Where exactly will the bond market rise in yield the most? Current studies show the very short part of the curve (Bills to 5 years) is most likely the most vulnerable. As of right now, we have:

1 year: 0.09%
2 year: 0.36%
5 year: 1.58%
10 year: 2.62%
30 year: 3.48%

Perhaps, once the US Government exits the bond manipulation game, we'll see Bills at 2.25%, 5s at 2.85%, 10s at 3.40% and the 30 year at 3.65%. This would be significantly flatter, with bear flattening all through the curve, but with the majority of damage on the short end. For many, this is the most intuitive shape of the interest rate rise simply because the Fed is manipulating the short of the curve the most extensively.

Keep an eye on curve shape, and don't assume that holding 5 year bonds absolves you of all risk. Again, the short end of the curve is being unnaturally manipulated and probably is the most vulnerable to change when the Fed exits.

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