Monthly Dashboard – A Flat Curve is Not a Curve

As global markets have been digesting the unfolding events in Ukraine, geopolitical developments are being balanced against the Fed’s expected interest rate increases and equally important sunsetting of quantitative easing (the buying of longer dated securities).  As short-term rates (Fed-controlled) are starting to increase, so have longer term rates (market-controlled), but at a much slower pace, so that currently whether one invests in 5 year Trearusys or 10 year, the yield is about the same.

In a typical rate increase cycle, monetary policy tightening (increasing of short-term rates by the Fed) is used to cool an overheating economy, eventually leading to a inverted yield curve (short term rates eclipsing long term rates), and most likely pushing an economy into a recession.  This scenario is particularly likely when inflation is admittedly not transitory as well as elevated well above the Fed’s self-determined 2% “stable” price level – exactly the situation we find ourselves now.  As a result, today’s flat curve is expected by many to be on its way to inversion – think of a see saw where the seat on the left has already been lifted off the ground, is currently balanced with the right, but is on its way of raising above the right, as the right drops down toward the ground.

The challenge for the market this time around, in addition to evaluating the severity of the war in Ukraine on a daily basis, is the elephant in the room, namely the $9 trillion Fed balance sheet that has effectively been controlling long term rates.  Taking the Fed’s asset purchase program in mind, we may have fibbed a little in the opening paragraph when we referred to long term rates as “market-controlled”.  In reality, we haven’t had any prolonged period of market-driven long-term rates since the 2008-2009 financial crisis.  With the current sunsetting of the Fed’s purchase program, it is quite fair to expect long term rates to continue their upward moves for some time, especially since inflation is becoming more endemic worldwide.  Then again, we would not put it past this Fed to resume asset purchases down the road, this time with the blatant goal of yield curve management – just like the Bank of Japan has undertaken for some time now.

As long as the employment outlooks is positive, and 10 years of post-financial crisis pent up demand for housing remains robust, the only release valve for market pressures on a manipulated yield curve could be on the relative value of the dollar.  As a result, we believe hard assets and real assets are likely to continue to outperform.