Tuesday, May 26, 2009
The Treasury yield curve has been as steep as it is today two other times in recent history. What's unusual about today's steepness is that, unlike the other occasions when the curve steepened, this one is being led not by a reduction in short-term interest rates but rather by a rise in long-term interest rates. Short-term rates have not changed much since the end of last year, but 10-year Treasury yields are up almost 150 bps. So this curve steepening is quite rare, since the bond market is the one leading the way, not the Fed. Most steepenings are driven by an easing of Fed policy (i.e., a lowering of short-term interest rates), typically in response to a weak economy.
This reiterates the point of my earlier post: the bond market is signaling that the Fed has probably eased enough for now and should begin tightening, because inflation expectations have picked up significantly.
Unless and until the Fed starts to reverse its massive liquidity injections, bond yields are likely to continue to move higher, and the yield curve is likely to experience an unprecedented steepness. We thus have the makings of a perfect Treasury storm here: long-term interest rates are being pushed higher as inflation expectations rise (fueled by easy money), and the pressure for higher rates will be intensified as Treasury embarks on the most massive bond sales by any measure since World War II.
Full disclosure: I am short Treasuries via a long position in TBT and a 30-year fixed mortgage at the time of this writing.
UPDATE: As my good friend Art Laffer keeps emphasizing, a steep yield curve is VERY good for banks, since they can borrow today at almost zero and lend along the curve at much higher rates. This is one reason that very steep yield curves almost always signal recovery.
UPDATE II: I think the upshot of all this is that we've seen an important tipping point; from now on, every day that the Fed doesn't withdraw some of the trillion dollars it has injected, the odds of a significant increase in inflation increase.
Posted by Scott Grannis at 1:01 PM