By Stavros Tousios FX Market Specialist, FXPRIMUS
By Stavros Tousios FX Market Specialist, FXPRIMUS

US economy – A view on interest rates and the yield curve

While interest rates (IR) have continued to climb on major fiscal policy reforms and a rising consumer price index (CPI), U.S Q1 2017 GDP growth rates reached their lowest level since 2014, albeit rising quarter-on-quarter when compared to Q4 2016, signalling that the US economy is slowing down. 

First Published: e-Forex Magazine 76 / Currency Clips / June, 2017

US economy – A view on interest rates and the yield curve

While interest rates (IR) have continued to climb on major fiscal policy reforms and a rising consumer price index (CPI), U.S Q1 2017 GDP growth rates reached their lowest level since 2014, albeit rising quarter-on-quarter when compared to Q4 2016, signalling that the US economy is slowing down. 

Minutes from the last FOMC meeting indicate that inflation is still on track, however, stubbornly slow in a decelerating economy. Policy makers are unlikely to avert from another IR hike at the June 14 meeting as a move towards unwinding Fed’s $4.5tn balance sheet. But, Fed must think cautiously as the probability of an IR increase and the surprise index have diverged significantly since May. A Fed policy mistake now could lead to a wider spread between the short and long-term treasury yields, or else known as the yield curve, a great predictor of future economic activity and inflation. The 10-year treasury yield declined 4.4 basis points during the latest Non-Farm Payroll data release as investors turned to more risk averse assets, whereas, it slid as much as 5.75 basis points since the election. The central bank could avoid June’s rate hike until the U.S economy strengthens as the Fed Fund rate (IR at which Banks charge one another overnight) has also been in an uptrend, getting closer to the short-term yield curve, which tell us where the US economy has been heading since Trump (see graph).

The spread between yields widened after the election and maintained momentum on investors’ fears over new administration policies, while the 10 and 5-year treasury yields (DGS10 and DGS5) flattened most in seven months. Yields moved towards pre-Trump lows, while the shorter-term yield (T10Y2Y) ended below pre-Trump levels. The Fed’s attempt to lift IRs away from the zero-interest rate policy (ZIRP), and towards rate normalisation, may cause a crossover between the short-term yield and the Fed Funds, which is an indication of fore-coming recessionary periods.

The unrealistic 3% a year predicted GDP forecast adds more inflationary pressure which may bring DGS10 further down than the current 136 points. This latest decline had no noticeable effect on May’s predicted real GDP growth, however, it signals that policy easing may be in play. Feds’ decision for lower rates could improve the curve over the intermediate term, higher rates could push the curve closer to recessionary periods. With the US Dollar falling c. 6% in the first half of 2017 fiscal and political uncertainty are still the economy’s biggest risks.