During 2018, the Federal Open Market Committee (FOMC) raised the Fed Funds Target Range four times, concluding with a 25 basis point hike to a range of 2.25%-2.50% in December 2018. However, in Q4 2018 and Q1 2019, longer term rates fell as economic data domestically and globally came in softer than expected and headlines surrounding trade discussions and Brexit weighed on investor confidence. Due to these factors, at the March meeting, the FOMC shifted their tone to a “patient” approach towards rate adjustments from the more hawkish tone in prior quarters and maintained that stance at the May meeting.
Rate Reductions Remain a Possibility
Recently, domestic economic data has improved, notably Real GDP and Labor Market data, but concerns remain about a slowdown in Europe and the outcome of trade negotiations. As a result of the market changes, the implied expectations for the path of short term rates now incorporates the possibility of rate reductions despite the FOMC’s projections, shown below, which indicate that members expect to hold rates constant in 2019, and increase the Target Range in 2020 by 25 basis points.
Yield Curve Continues to Flatten, then Invert
The result of these conflicting moves was a continued flattening of the yield curve, with the benchmark difference between the 10-Year Treasury and 2-Year Treasury yields falling to a low of 10.7 bps in December 2018.
Simultaneously, in the “belly of the curve”, between 3 and 5 years, the moves caused an inversion, where the yield on the longer dated 5-Year Treasury fell below that of the 2-Year and 3-Year Treasury. Currently, the 5-Year Treasury yield is 1 basis point lower than the 2-Year Treasury Yield, but the Treasury yields of all tenors less than 30 years remain below 3M LIBOR.
How to Take Advantage of the Yield Curve
Borrowers can take advantage of the flat and inverted yield curve by extending the duration of swaps for historically low premiums, and in some cases locking in a fixed rate that falls below current short term floating rates. To illustrate, the current cost to swap a 1M LIBOR loan for 10 years is (13) bps, improving borrowers’ cash flow while locking in a long term cost of capital. The inversion is even more pronounced for 5 and 7 year swaps, with the fixed rates 29 and 23 bps cheaper than 1M LIBOR.
Market participants are split on the direction of both short-term and long-term rates in 2019, and both have the potential to swing rapidly following the release of domestic and global economic data. Although the FOMC is predicting one 25 basis point hike in 2020, PNC Economics currently does not have a hike or cut included in their forecast but projects the 10-Year Treasury yield to climb slowly for the remainder of the year to 2.62.
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Look for future articles on rate movements. In the meantime, we invite you to reach out to your PNC Relationship Manager or derivative marketer.