Just how much is the Fed shaping the yield curve?
Investors who have been paying attention to the Fed know that it has raised rates eight times since late 2015 and that this has lifted the short end of the yield curve.
Perhaps less well known is that since October 2017, the Fed has reduced the size of its balance sheet by approximately $340 billion. But that hasn’t meant that it has stopped buying bonds altogether.
The pre-determined pace of Fed tapering, now at $50 billion per month, combined with the maturity schedule of the bonds on its balance sheet, has meant that the Fed has still purchased hundreds of $billions worth of bonds over this period.
Worth noting, however, is where on the curve it has focused its buying; more than 90% has gone into bonds maturing by 2028.
On December 3, 2018, the yield on the 5-yr Treasury fell below the yield on the 2-yr Treasury, a condition that the Fed seems to have contributed to.
By virtue of raising the Fed Funds rate, it has pushed the 2-yr yield higher; by virtue of focusing its purchases on intermediate tenors, it has generated downward pressure on the 5-yr.
Meanwhile, as the short end has been flattening into inversion, the long end has been getting steeper, with an expanding gap between the 30-yr and 10-yr yields. It is arguably no coincidence that the Fed has carried out very little of its buying activity in that stretch of the curve, evidenced in the chart by the lack of any difference between the light and dark blue bars in the years 2035 and longer.
As of December 6, 2018, the futures market indicated a 64% probability of a rate hike at the Fed’s meeting on December 19, 2018. With the 2-yr at 2.70% and the 10-yr at 2.86%, investors may well see more of the curve invert before the year is through.
Unless otherwise noted, data is sourced from Bloomberg.
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