In April, the 10-year Treasury yield moved above 3%, the first time since January 2014. At the same time, the interest rate curve continued to flatten and now sits approximately 50 bps from inversion. Are these signs worrisome? We don’t believe so.

3%: WHY IT MATTERS…AND DOESN’T

The move above the 3% threshold is garnering a lot of media attention because some are concerned that as 10-year rates rise, the economy will slow as borrowing costs become more expensive. While this is a valid concern, we believe the US economy should be able to continue to grow and withstand interest rates at or above 3%. In fact, we expect yields will rise this year to 3.25%. But this begs the question: Why are rates rising? One reason is a rise in short-term rates.

Entering 2018, everyone expected the Federal Reserve to continue raising their target range, including us. In fact, our forecast called for a 1% increase or four rate increases from the Fed. In conjunction, the Fed is also continuing to reduce its balance sheet. Together, these monetary policy influences have contributed to, and should continue to promote higher longer-term rates. But there are also other factors causing longer-term rates to move up.

The recent tax legislation and passed budget, which increase spending by the federal government, are targeted at improving growth, but may also push inflation higher. This will likely translate into increased debt issuances over the next several years to pay for these policies, which will also likely push yields higher. How does it impact borrowers as well as return-seeking assets, like stocks?

NOT ALL GLOOM AND DOOM

The influence of higher interest rates cannot be looked at in isolation. At the moment, rates are rising against a backdrop of a fairly healthy economic environment. If the economy continues to perform well, consumers and corporations should be able to absorb the higher cost of borrowing.

That said, financial markets will likely be influenced by these higher rates. Although we expect solid growth across the globe this year, rising rates do suggest higher volatility. The reason is simple. The Fed is now stepping back its influence on economic activity, by raising rates and reducing its balance sheet, which likely causes investors to be more jittery since the safety net that the Fed previously provided is now somewhat smaller.

CAN A CURVE BE FLAT? YOU BET

Bond market participants often talk about the yield curve and its shape. The yield curve reflects what interest rates are being offered for all maturities of bonds, from very short to very long. A “normal” shaped curve is one in which shorter-term rates are lower than longer-term rates whereas a flat curve means that shorter-term rates are very similar to longer-term rates. Since the end of 2013, the US Treasury yield curve has been flattening, with the difference between the 2-year and the 10-year yields now around 0.50% .

It is normal for the yield curve to flatten during a Fed tightening cycle, as it is usually driven by higher rates at the short end, which is the case right now. But fears of the curve inverting, where short-term rates are higher than long-term rates, are becoming more widespread. That’s because inverted curves typically precede recessions.

An inverted curve is generally reflective of economic conditions that cause a recession. One condition is a move higher in short-term rates through tightening by the central bank; another is declining investor economic growth expectations which tend to move long-term rates lower as investors buy bonds for safety.

However, it is important to note that not all flat curves invert. In the 1990s, for example, the curve flattened and stayed flat for several years without inverting. That said, they do tend to be a good predictor of an economic contraction, but are not predictive of when a contraction will occur. So, what does this mean for today’s curve?

WHY MIGHT THIS CYCLE BE DIFFERENT?

Over the past 10 years, monetary policy, primarily quantitative easing (QE) in US, Europe, and Japan, has distorted the relationship between the economy and interest rates. While the US Federal Reserve has stopped buying assets, the European Central Bank and Bank of Japan are still buying their own bonds, pulling down their yields. As a result, US Treasury interest rates look relatively attractive, inducing international buyers to purchase US bonds, anchoring longer-term rates. So, while rates have risen across the curve, they’ve risen less at the long end due to this dynamic.

Fortunately, this influence is a supply/demand issue and not a result of lower growth or higher inflation. So, we do not view this type of flattening as an imminent sign of the end of the cycle.

BOILING IT DOWN

It is always important to watch the movement of interest rates and the relationship between short- and long-term rates. Currently, we believe rates are rising and the curve is flattening due to a confluence of factors: the Federal Reserve raising rates, a solid economic landscape, rising inflation, fiscal policy, and the anomalous contribution from QE abroad. At the moment, nothing seems particularly worrisome to us, but we will watch how these issues evolve and what it means for interest rates, the economy, and all asset classes.

For more on trends in the economy, markets and asset allocation for long term investors, explore The Pulse, a Bernstein podcast series, and for additional thought leadership, check out the related blogs here.

The views expressed herein do not constitute research, investment advice, or trade recommendations and do not necessarily represent the views of all AB portfolio-management teams.

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