The yield curve will continue to flatten as the Federal Reserve raises short-term rates several more times while long-term rates edge only slightly higher, according to strategists at Schwab Center for Financial Research.
But that doesn’t mean fixed income investors should expect a recession is around the corner or favor only the short end of the curve, says Kathy Jones, chief fixed income strategist. She notes that many clients are buying short-term CDs and Treasury bills but as the cycle progresses, they should add duration, moving beyond two-year issues for some portion of portfolio. “No one has a three-month time horizon for investing,” says Jones.
The current spread between two-year and 10-year Treasuries is around 25 basis points, down from 85 a year ago and 125 basis points in January 2017. Ten-year Treasuries are yielding just over 3% and two year-notes near 2.8% while the federal funds rate ranges between 1.75% and 2%. It’s expected to rise another 25 basis points following next week’s Federal Open Market Committee meeting.
Collin Martin, director, fixed income at the Schwab center, who spoke with Jones at a morning meeting with reporters, says it will take two to three more Fed hikes before the yield curve flattens, and the flattening is not a signal of impending doom.
Longer term the explosion of the U.S. government debt, however, will be problematic. The debt-to-GDP level is now 104%, due in large part to the recent tax cuts that will add about $1.5 trillion to the deficit over 10 years. “You have to finance the deficit with debt issuance and at a certain level investors will demand high yields,” says Jones.
She says the growing debt-to-GDP ratio is “worrisome” and could crowd out private investment at some stage if its growth trajectory doesn’t slow. “I don’t believe we can grow out of it,” says Jones, refuting the argument propagated by supporters of the tax cut.