A hawkish shift from the US Federal Reserve in its last meeting on June 16th has focused attention once again on the shape of the curve which ultimately is said to reflect the expected trajectory of the economy. The yield curve normally has an arcing, upward slope because investors expect more compensation for taking on the added risk of owning government debt as maturities grow longer. If the gap between yields at the shorter-maturity, usually measured by the two-year interest rate, and longer-term debt as reflected by the ten-year rate, widens substantially, the yield curve is said to be steeping which could signal expectations of higher economic growth and inflation.

At the start of the year, the gap between these two interest rate levels was 0.82 percentage points. Fast forward by three months and the gap widened to 1.58 percentage points, almost all because of a rise in long-term yields. A marked shift in fiscal policy in America was a big influence. By March, a bumper $1.9trn spending bill had been signed into law and additionally it was mentioned that an even bigger package to finance infrastructure was in the works as well.

Yet in early April, the curve began to flatten. The yields on two- to five-year Treasury bonds move up as money markets began to price in the prospect that the Federal Reserve would raise interest rates in 2023. There were bigger moves at the long end of the curve. By the end of last week, the ten-year yield had fallen to 1.52%, more than 0.2 percentage points lower than at the end of March. The 30-year yield fell by even more.

The decline in long-term yields started long before the June Fed meeting, where it sounded a more hawkish tone on inflation. At this latest meeting, a majority of policymakers shifted their projections for the first interest rate hike into 2023 amid signs of accelerating inflation, surprising markets and sparking a sharp rise in yields on two- and five-year notes, which are the most sensitive to interest rate changes. Long-term yields subsequently fell further, flattening the yield curve between five-year notes and 30-year bonds, with the gap shrinking to its narrowest since August 2020.

The message from all this seems to be that, the early-cycle phase, in which risky assets are embraced almost without discrimination, may be close to an end. The peak in economic growth may have passed. The prospect of further fiscal stimulus is also more uncertain, as America’s infrastructure bill will now have a far smaller price tag than the original $2trn-$3trn figure widely touted just weeks ago.

Markets are forward-looking and it seems that they have now less to look forward to. If peak GDP growth is behind us, the scope for further upward revisions to forecasts for company earnings are limited. The US indices already trade at a high multiple of prospective earnings. A lot of good news is already priced into risky assets. In the absence of fresh influences to drive prices up, risky assts are vulnerable to declines.

Disclaimer: This article was written by Stephen Borg, Head of Private Clients at Calamatta Cuschieri. The article is issued by Calamatta Cuschieri Investment Services Ltd and is licensed to conduct investment services business under the Investments Services Act by the MFSA and is also registered as a Tied Insurance Intermediary under the Insurance Distribution Act 2018.

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