Rising Fed Rates Do Little To Yield Curve

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Includes: CSJ-OLD, IEF, UUP
by: Das Kapital

Summary

The Treasury yield curve continues to flatten.

This comes even as the Federal Reserve is hiking rates.

With the yield curve flattening, the U.S. dollar could have trouble moving higher in 2016.

The Federal Reserve chose to raise its benchmark rate in December, but it did little to raise the Treasury yield curve. In 2015, the Treasury yield curve, represented by iShares Barclays 1-3 Year Credit Bond (NYSEARCA:CSJ-OLD) over iShares Barclays 7-10 Year Treasury (NYSEARCA:IEF), trended sideways. This signals that although the Fed believes it is ready to tighten policy, the economic background may not be as certain.

In a healthy economy, the yield spread between two and ten-year Treasuries expands, represented by a rising indicator below. In 2013, when U.S. policymakers originally hinted at raising rates, the market was caught off guard and bid the curve significantly higher. In 2014, as both economic activity remained gradual and the market began pricing in a moderate raising of rates, the spread declined, then began to trade sideways.

Currently, low inflation in the U.S., declining factory activity, and suppressed commodity prices could weigh on investors' enthusiasm for risk assets. Acknowledging such weakness, the yield curve may continue in its range as investors keep interest rates suppressed in a fragile economic environment.

PowerShares DB US Dollar Index Bullish (NYSEARCA:UUP) could face trouble moving higher with the yield curve suppressed. Fed rate hikes generally entail strength in the dollar, but not as often when the yield curve flattens. Furthermore, the flat yield curve could signal there will be fewer additional hikes by the Fed in 2016 than many expect.

If the Fed does hike only once or twice next year, this will be viewed as a dovish stance, driving bonds higher and the dollar lower. The ultimate takeaway is that as long as the yield curve indicator is in consolidation at low levels, the U.S. dollar will not have the strength to move considerably higher.

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