US yield curve interactions: The Fed, volatility and the economy - Rabobank

Research Team at Rabobank, suggests that the Fed rate hikes, rising inflation, jumps in market volatility and changes in nonfarm payroll growth affect the level and the slope of the US treasury yield curve.

Key Quotes

“The upward impact on the level of the yield curve from a Fed rate hike can be offset by a rise in risk perception, especially at the longer end of the curve. However, the tightening of the 2-10 spread is very difficult to overturn. The conflicting effects of Fed hikes and volatility jumps on the level of the yield curve underline the importance of the Fed’s cautious and gradual approach: only if markets are comfortable with a hike, the Fed will be able to steer longer term rates in the right direction. Otherwise, the hike will be counterproductive. This could occur if the hawks win the debate in the FOMC too early, at least in the market’s opinion.

The curve steepening caused by a sustained rise in inflation can be offset by subsequent Fed hikes, which could even lead to curve flattening on balance. While Fed hikes can overturn the impact of higher inflation on the slope of the yield curve, they do so by reinforcing the upward impact on the level of curve. This scenario is particularly relevant if the Fed waits for inflation to rise before resuming its hiking cycle, which is actually the preferred scenario of several doves in the FOMC.

In contrast, the curve flattening caused by an acceleration of nonfarm payroll growth would be amplified by subsequent Fed hikes. They would also reinforce the impact on the level of the yield curve.”