Tuesday, May 26, 2009

Very steep Treasury curve -- time to tighten


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.

12 comments:

The Lab-Rat said...

You might be right but I can't help thinking market manipulation is the cause of the steep curve, not the bond market reading ahead. Indeed, the over-stimulus is likely to persist which would mean a complete loss of confidence in the long end so the curve could well go much, much steeper. 5s30s @ 400, why not?

Scott Grannis said...

I don't think we disagree. The steep curve is being driven by the bond market in reaction to the Fed's blatant ease. Deflation fears have been replaced by the beginnings of inflation fears. Treasury bonds were the safe harbor for lots of investors, now they have to look elsewhere for shelter. Lots of assets could thus benefit from the Treasury selloff. Equities have been priced to a depression and deflation, now those risks are vanishing and the economy is once again growing. The curve could steepen a lot more and equities could rally a lot more, why not?

GaryNJ said...

Well, what do you think about TIPS (and TIPS-based ETFs)? Gary

Scott Grannis said...

Be sure to check out all the posts I have on TIPS (lots). The short answer is that TIPS look attractive because the bond market has not priced in the likelihood of a meaningful rise in inflation. I doubt that you will make much money via price appreciation (due to falling real yields) if you buy TIPS today, but you are likely to receive a nice income stream. They look especially attractive relative to Treasuries and they are a compelling alternative to holding cash for the next few years.

Holding TIPS via ETFs is probably a good idea for most small investors.

Spiral said...

Scott,

What do you think of this idea from William Poole at the Cato Institute. (Sorry for being slightly off topic.)

A Market Solution to Secure Banks' FutureHere is a proposal, not at all original but deserving of serious public discussion. As a condition of enjoying the benefits of a bank charter, every bank must issue 10-year subordinated notes equal to 10 per cent of its total liabilities. The specification can be adjusted, but this one serves to illustrate the proposal. The subordinated debt would be unsecured; holders would stand last in line among all creditors in the event that a bank had to be shut down. The sub debt requirement would be in addition to existing requirements for equity capital.

Pat said...

Right on Scott. Wish you were still working (for us). Most folks don't remember the 70's

Pat said...

Right on Scott. Wish you were still working (for us). Most folks don't remember the 70's

MW said...

Same story in most currencies (EUR, SEK, CHF, GBP...), where the CB is not debasing the ccy (i.e. ECB and EUR). Short-end is anchored, so all the selling pressure is further out on the curve.

MW said...

EDIT: that last post should read "even where the CB is not debasing the ccy".

jarda okurka said...

"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"

rising interest rates is a "sure good thing" for housing market. the higher interest rates, the higher number of defaults in real economy (mortages and corp loans) in this kind enviroment. who is going to eat the losses? banks.

Scott Grannis said...

Higher interest rates are not necessarily bad for the economy. Households in aggregate have more floating rate assets than floating rate debt, so households are net beneficiaries of higher rates. Anyone who has refinanced at a fixed rate benefits because he has locked in his costs. At some point higher rates will hurt housing, but we're not even close to that point yet. Rates are still very low historically.

Scott Grannis said...

MW: good point. Steep curves are a universal sign of easy money.