Does a Flatter Yield Curve Mean the Fed Will Raise Rates Next Year?

There is a never-ending debate among fixed income investors regarding the Federal Reserve and how the Fed’s Open Market Committee will set monetary policy.  We have written many times on this topic over the past few quarters and hypothesized that a strengthening domestic economy will cause the Fed to move off the lower bound of a zero fed funds rate at some point during 2015.  Given this outlook, fixed income investors are wise to have minimal exposure to bonds maturing in 4-6 years, the “belly of the curve” as we call it.  The market has caught on to this idea over the course of 2014.  As shown on the chart below, longer-term U.S. Treasury yields have fallen this year on global economic concerns, while 5-year rates have not followed suit, remaining virtually unchanged as investors anticipate a policy shift in the near future.
Driven by a strong employment report on Friday, last week saw a fairly significant sell-off in the bond market, led by the 5-year portion of the curve. 

There are two important takeaways from this price action: 1. It is not always a bad thing to own longer-term bonds when the Fed raises the fed funds rate, and 2. The under-performance of the 5-year portion of the yield curve is making that tenure of bond attractive again.  You may see us make trades in the coming weeks to exploit these themes.

Source: Bloomberg