What Drives the Yield Curve?

The Treasury yield curve, on its surface, can be daunting. It is a visual depiction of the yields of all different maturities of benchmark Treasury bonds. In fixed income, virtually all segments of the market are evaluated relative to the Treasury yield curve. In high-yield, for instance, valuations are often interpreted by looking at the “spread” between the yield of high-yield and the yield of comparable maturity Treasury bonds. This spread accounts for things like the increased risk of high-yield, the greater chance of default by high-yield companies, and the lower liquidity (ability to buy and sell easily without price fluctuation) of these securities relative to Treasury securities.

Many factors contribute to the shape of the yield curve. Different segments of the Treasury yield curve are driven by different factors. Given the outsized attention the Federal Reserve (Fed) has received in recent years, one common myth worth dispelling is that the Fed controls all interest rates. Although it is true that the Fed has a lot of influence over shorter-maturity Treasury yields (the “short end” of the yield curve), expectations of future growth and inflation are dominant forces in longer-maturity Treasury yields (the “long end” of the curve) (see the figure below).

09-26-16-blog-fig1_1

Market reactions to events can help illustrate the many drivers of different segments of the yield curve. The Fed’s policy wing, the Federal Open Market Committee (FOMC), recently met to announce its decision on whether to raise the short-term benchmark interest rate, the fed funds rate, or whether to hold it at its current level. The FOMC held rates at their current levels, more or less in-line with market expectations. The FOMC did, however, lower its projections for future rate hikes and for U.S. gross domestic product (GDP) growth over the medium and short term. Shorter-maturity portions of the curve did not move substantially, with the yield on the 1-, 2- and 3-year Treasury little changed. Yields at the longer end of the curve, however, fell in subsequent days, as the market digested lower projections for domestic growth and inflation.

The yield curve is complex; it reflects investors’ expectations of future interest rates, inflation, growth, and actions taken by the Fed. Different sections of the curve are driven by different phenomena, and dissecting those various parts can make the story slightly clearer.

IMPORTANT DISCLOSURES
Past performance is no guarantee of future results.

The economic forecasts set forth in the presentation may not develop as predicted.

The opinions voiced in this material are for general information only and are not intended to provide or be construed as providing specific investment advice or recommendations for any individual security.

Bonds are subject to market and interest rate risk if sold prior to maturity. Bond values and yields will decline as interest rates rise, and bonds are subject to availability and change in price.

Government bonds and Treasury bills are guaranteed by the U.S. government as to the timely payment of principal and interest and, if held to maturity, offer a fixed rate of return and fixed principal value. However, the value of fund shares is not guaranteed and will fluctuate.

This research material has been prepared by LPL Financial LLC.

To the extent you are receiving investment advice from a separately registered independent investment advisor, please note that LPL Financial LLC is not an affiliate of and makes no representation with respect to such entity.

Not FDIC/NCUA Insured | Not Bank/Credit Union Guaranteed | May Lose Value | Not Guaranteed by any Government Agency | Not a Bank/Credit Union Deposit

Securities and Advisory services offered through LPL Financial LLC, a Registered Investment Advisor
Member FINRA/SIPC
Tracking #1-537878 (Exp. 09/17)