What the Yield Curve Is Saying About Monetary Policy

Is a regime shift in monetary policy imminent? One might think so looking at the yield-curve flattening trend—the 5-year and 30-year Treasury yield spread has narrowed 75 basis points (bps) since September 2017 and appears to be on track to flatten entirely.

From my vantage point on the trading desk, it seems investors are beginning to believe that the Federal Reserve (Fed) has become comfortable with shifting from an accommodative policy stance to a restrictive policy stance much sooner than previously expected.

Assessing the policy stance

We assess the Fed's monetary policy stance by observing the difference between the Fed's nominal policy rate, which is currently at about 1.7%, and a measure of the neutral nominal rate (the estimated neutral real rate,[i] or r-star, plus the Fed's 2% inflation target). While there are varying opinions and a great deal of uncertainty regarding the level of r-star, the most commonly cited models suggest that the r-star is currently somewhere between 0% and 0.50%, which implies a current neutral nominal policy rate of between 2% and 2.5%.

When the Fed’s policy rate is below the neutral rate, monetary policy is considered to be accommodative. When the Fed’s policy rate is above the neutral rate, monetary policy is considered to be restrictive. By this measure, since the Fed’s December 2015 “lift-off,” its policy stance has gone from approximately 175 to 225 bps accommodative to just about 25 to 75 bps accommodative. If we assume a relatively stable neutral rate in the near term, the Fed appears to now be only a few hikes away from transitioning to a restrictive policy stance for the first time in more than a decade.