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Yield curve positioning

Investment Insights • Infocus

2 min read

Yield curve positioning

The US Federal Reserve appears to be nearing the end of its rate tightening cycle. Sam Jochim analyses the implications for fixed income investors and assesses yield curve positioning.

Sam Jochim
Sam Jochim

Having risen sharply from mid-2020 until mid-2022, inflation in the US appears to have peaked and is in a declining trend. Despite the Fed’s dramatic tightening of monetary policy, involving 500 bps interest rate increases over 14 months, inflation remains above the Fed’s 2% target. While headline inflation has come down, core inflation, which excludes the volatile energy and food price components, has remained more persistently elevated. At 5.5%, it is far above the Fed’s 2% objective. Debate therefore continues regarding whether the Fed is likely to increase interest rates further.

Market expectations regarding interest rates have moved quickly. As recently as 08 March, markets expected the Fed funds rate to be 50 basis points above its current level after the FOMC’s June meeting with a good possibility of further hikes at subsequent meetings this year.

However, following recent bank failures, it became evident that one trade-off the Fed faces is between stabilising inflation and ensuring financial stability. As a consequence, rate expectations quickly shifted and rate cuts are now anticipated towards the end of the year.

This shift in expectations has been associated with a rally in fixed income markets. Treasury yields declined by around 40 basis points on average across the term structure from 8 March to 12 May.

At the press conference following the latest FOMC meeting, Chairman Powell stated that it was more likely than not that the US would avoid a recession this year. If there is a recession and it turns out to be deeper than expected, for instance because credit conditions tighten further, the Fed may cut rates by more than markets currently anticipate. However, if the labour market remains tight and core inflation persistently elevated, and the Fed adopts a more hawkish tone, it is possible markets begin pricing in more rate hikes. Risks today are in both directions and each scenario would have important implications for fixed income markets.

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