Interest Rate Outlook

With the job market showing some signs of improvement and the Fed beginning to take into account broader economic factors, it’s a good bet we’ll start to see interest rates rise in the near future.

ADP Employer Services reported that the economy added 201,000 jobs in March. That followed a 208,000-job gain in February. A separate report from the outplacement firm Challenger, Gray & Christmas showed that layoff announcements plunged 39% year-over-year in March to only 41,528.

Even with this stronger showing in the last two months, unemployment remains high, and the rest of the world is doing much better than the U.S. But clearly domestic labor demand is improving. 

Fed officials are already talking tougher about interest rates, and we expect that trend will likely continue. After considering this latest labor market news, it’s undoubtedly time to position for a flatter yield curve. More specifically, we expect that short-term yields will rise more quickly than long-term yields as bond investors price in a more hawkish Fed.

When you hear talk of the yield curve, it refers to the chart of yields on Treasury obligations of varying maturities. As an investor, you certainly would expect better returns for the risk of having your money tied up for a longer time. So, usually, the yield curve shows higher returns for longer-term maturities. But, depending on the economy and the outlook for the future, the yield curve can shape quite differently.

A flat yield curve reflects a market where there is little difference between short and long term rates for bonds of similar credit quality. As the yield curve flattens, investors aren’t getting compensated for the added risk of holding a security for the longer term. For example, when the yield curve is flattening, the difference in yield between a 1-year and a 30-year bond is relatively small.

The yield curve shows the market’s expectations for future interest rates. So when the yield curve changes shape, it’s time for investors to re-evaluate their outlook on the economy.  Remember, as interest rates increase, the price of a bond will decrease and its yield will increase.

A flat curve generally occurs when the market transitions. In this case, it seems that while a rise in short-term rates is anticipated, the rise is not expected to be echoed by longer-term rates.

There are Exchange Traded Notes (ETNs) designed to rise in value when the yield curve flattens.  Now would be a good time to consider this type of investment. 

Editor’s note: To receive Mike Larson’s regular updates with more in-depth advice and trading recommendations that will help you take advantage of current and expected interest rate moves, subscribe to Interest Rate Profits.