Current flatness is the UST curve more consistent with the early stages of a Fed hike cycle

The UST curve is unusually flat given where we are on the monetary policy cycle. The 2Y/10Y spread has compressed from 265bps at the beginning of 2014 to 128bps currently. During the 2004/2006 cycle, this level of slope steepness was seen after the Fed had hiked multiple times. There are two key reasons for why the UST curve is so flat in the current cycle. 

Firstly, there has been tremendous downward pressure on headline inflation over the past six quarters. Most of this can be attributed to a slump in commodity prices that was exacerbated by China worries. Notably, the CRB index is down by 37% (the prolonged slump in the oil prices playing a big factor) over the same time period, putting tremendous downward pressure on inflation expectations and longer-term UST yields. 

Secondly, the market is complacent about interest rate risks over the Fed normalization cycle. A re-pricing higher in the front-to-intermediate segment of the curve is likely once there is greater clarity on the pace of Fed hikes. To summarize, Fed liftoff is about to take place in a period where headline inflation is low, thereby accounting for a flat curve. 

"We still see scope for further flattening, but we suspect that the pace could moderate. Barring another sharp downleg in commodity prices, inflation expectations should pick up, driving longer-term UST yields higher over the coming quarters", says DBS Group Research.