By Senior Advisor Kirk Ludwig, AIF®.
In September 2024, the Federal Reserve started lowering interest rates after a long stretch of raising them to combat inflation. This marked a notable shift, as the Fed appears to have achieved a soft landing - taming inflation without derailing the economy. But here’s the catch: not all rates have followed suit. In fact, some rates are higher today than they were at the start of the year. Below is a graph of the Treasury yields along the maturity spectrum at the beginning of the year and the end of the year, known as the yield curve, and reflecting the changing market sentiment.
Source: “Daily Treasury Par Yield Curve Rates”. U.S. Department of the Treasury, 02-Jan-2024 through 31-Dec-2024, treasury.gov. See Important Disclosure Information.
At the start of the year, short-term interest rates were elevated due to aggressive Federal Reserve action to manage inflation. Over the year, inflation levels eased, and the Fed shifted to lowering rates, and short-term yields followed. But the longer-term rates have risen, incorporating expectations for growth, inflation, borrowing needs, and many other factors. This divergence tells us something important: while the Fed controls the Fed Funds rate, the market determines all other rates. The front end of the yield curve reflects what the market thinks the Fed will do next, while the back end reflects everything else into the future.
The yield curve isn’t just an academic concept; it impacts real-life decisions. If you’re watching your money market yields, you’ve likely noticed they’ve been dropping. On the other hand, if you’re shopping for a 30-year mortgage, rates have drifted higher. For investors, money market and short-term bonds are experiencing lower yields, while longer-term bonds are paying more income. That’s not to say that you should be shifting everything to longer maturities; it just simply means that the market is pricing future risk differently. Paying attention to maturity terms is critical, and that’s why we focus on the shift in all interest rates - not just the Fed Funds rate.
The yield curve has often been labeled the market’s crystal ball, supposedly predicting recessions and expansions. But a crystal ball might be giving it too much credit. A Magic 8-Ball is probably more fitting - you shake it and get a random answer like “Ask again later” or “Outlook not so good.” What the yield curve does exceptionally well is capture the collective thoughts of the market today. It’s a snapshot, not a prophecy, and tomorrow’s new information could change the picture entirely.
Important Disclosure Information:
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Statements contained in this article that are not statements of historical fact are intended to be and are forward looking statements. Forward looking statements include expressed expectations of future events and the assumptions on which the expressed expectations are based. All forward looking statements are inherently uncertain as they are based on various expectations and assumptions concerning future events and they are subject to numerous known and unknown risks and uncertainties which could cause actual events or results to differ materially from those projected.
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