Thursday, January 20, 2011
Today the spread between 2- and 30-yr Treasuries reached a new all-time high of 398 bps. This is an unequivocal indication that the Fed's effective policy stance is ultra-accommodative. The yield curve almost always steepens a lot coming out of recessions, because the Fed typically shifts to easing mode as the economy enters a recession, and then reaches full-bore easing in an attempt to help the economy dig out of its recession hole. This cycle has been no different from many others, with the main difference being that the funds rate has never been at or close to zero before.
A very steep yield curve such as we have today is also the direct result of the bond market's expectation that short-term interest rates will not remain at or near zero forever—starting sometime around the end of this year, the market expects the Fed to begin hiking rates, reaching 4% within 5 years' time. That too is typical as business cycles mature.
And as the top chart suggests, a steepening of the yield curve is also strongly indicative of rising inflation expectations. The only mystery about recent market action this year is the failure of 5-yr, 5-yr forward inflation expectations to rise in line with the ongoing steepening of the curve. It may be the case that intermediate TIPS breakeven spreads are being distorted by the Fed's ongoing Treasury purchases. Higher inflation expectations over the next 5 years would require higher nominal yields—but those are being held down by Fed purchases—and/or lower TIPS yields—but those are already negative out to 5 years. The path of least resistance for now would appear to be a further decline of short-term TIPS yields into negative territory (i.e., a further increase in the prices of short-maturity TIPS), a prospect that nevertheless must be daunting for many investors to contemplate. But with the ongoing rise in commodity prices, investors may eventually conclude that accepting a negative real yield is the price one must pay for inflation protection.
Posted by Scott Grannis at 5:51 PM