Note: Data is current as of March 1, 2018.
After raising the Fed Funds Target Range three times in 2017, from ½ to ¾ percent to 1-¼ to 1-½ percent, the Federal Open Market Committee (FOMC) has indicated it expects to do the same in 2018. The FOMC’s projections, colloquially referred to as the “Dot Plot,” show that the median expectation of FOMC members is for three additional hikes of 25 bps in 2018, thereby arriving at a Target Range of 2.00%-2.25% at the end of 2018.2
Market participants, as indicated by pricing on Eurodollar futures, are highly confident in at least two rate hikes this year, and slightly less certain of a third hike with implied probabilities around 64% likelihood as of March 1, 2018.3 However, it’s worth noting that this is quite similar to 2017, when the FOMC also projected three hikes, while the market had only priced in two hikes at the beginning of the year. PNC Economics believes the FOMC’s projections will prove to be most accurate again in 2018, following through on its plan for three hikes during the year (see supra note 1).
Throughout 2017, and continuing into early 2018, the U.S. Treasury yield curve flattened to levels not seen since 2007. For example, the difference in yields between the 10-year Treasury and the 2-year Treasury fell to just 60 basis points4 on March 1, 2018, as long-term rates remained historically low while short-term rates rose in response to FOMC rate hikes. The 10-year Treasury yield fell 4 basis points in 2017 to 2.40%, while the two-year yield climbed by 70 basis points to 1.88%.5 A combination of transitory factors have kept long-term rates low during a period of otherwise strong job growth and moderate economic expansion, including foreign demand for higher yields, global central bank stimulus programs and lower than expected inflation.
Eligible borrowers can take advantage of the flat yield curve by extending the duration of their existing swaps for historically low premiums. To illustrate, the current cost to swap a LIBOR loan for 10 years is 108 bps, only 15 bps more than the cost to swap for five years and just 8 bps more than the cost to swap for seven years.6
Market participants generally expect both short-term and long-term rates to rise in 2018, as the U.S. economy continues to improve. FOMC members have previously noted that the pace of rate hikes has been tempered by lower than expected inflation. However, recent metrics on wage growth, rising consumer prices, increasing oil prices and the stimulative impact of the new tax plan could cause the FOMC to raise rates more rapidly to combat inflation. Additionally, there is pressure on the long end of the yield curve. The supply of Treasuries is expected to increase due to rising government budget deficits, while demand for Treasuries is anticipated to decline as the FOMC and European Central Bank reduce or unwind their stimulus plans (the FOMC initiated a balance sheet reduction plan in October 2017 that calls for up to $252 billion in Treasuries to mature in 2018 and not be reinvested). As a result, PNC Economics believes the 10-year Treasury will end 2018 at 3.09% (see supra note 1), in line with broader market projections, and the highest level since early 2014.
1 PNC Economics, February 2018 Baseline Rate Forecast, February 15, 2018
2 Federal Reserve Press Release, February 1, 2017 & Federal Reserve Press Release, December 13, 2017.
3 Bloomberg; WIRP as of March 1, 2018
4 Bloomberg; USYC2Y10 INDEX: 60.112 basis points, March 1, 2018
5 Bloomberg; USGG10YR INDEX (1/2/17: 2.4443%, 12/31/17: 2.4054%), USGG2YR INDEX (1/2/17: 1.1883%, 12/31/17: 1.8830%)
6 Bloomberg; 3/1/2018 1m Libor (US0001M INDEX): 1.68620%, 3/1/2018 10Y Swap vs. 1mL (USSW10A CURNCY): 2.7637%, 3/1/2018 5Y Swap vs. 1mL (USSW5A CURNCY): 2.6163%, 3/1/2018 7Y Swap vs. 1mL (USSW7A CURNCY): 2.6876%
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