Thursday, January 20, 2011

Treasury yield curve is now steeper than ever before



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.

10 comments:

Public Library said...

Amazing stuff. Great post. Where the dam bursts nobody knows...

Dr William J McKibbin said...

Technical indicators on bonds set aside, what about the fundamentals, such as the recent report in the NY Times that US policy-makers (specific Republicans in Congress are named) are preparing a path for states to proceed into bankruptcy court -- more at:

http://wjmc.blogspot.com/2011/01/us-policy-makers-preparing-for-state.html

Bonds are looking very scary to me right now...

randy said...

The new Republicans are talking about many things - is this just more rhetoric that got press, or something that has legs? I doubt it. Far more likely is something like Mr. Spiotto in the NYT article describes - a federal program to take over state pensions that are beyond recovery. We can only hope that along with that is some mechanism for renegotiating the public pension gravy train promises going forward.

Benjamin said...

A rising tide lifts all boats--including our states.

Dow up 50 or so today.

If this is QE, bring it on, baby, bring it on. Pour it on Bernanke, rip out the corks, tip the barrels over set the damn house on fire.

Really, I don't think the USA is inflation prone anymore. Unions are dead, and capital, goods, services, and labor flow into the USA when demand goes up, thus dampening inflation.

Wan to charge more for you labor, your cars, furniture etc.? Too bad--the stuff is pouring in from all over. Add to that a glut of all kinds of space, commercial and residential.

We will see inflation about the time Tiny Tim beats up Shaq O'Neill/

You can't even charge too much for your capital, because there mountains of that too.

We could see some long good times ahead. I suspect we are on the cusp of a long secular bull market. this thing could have more legs than a centipede.

Some moderate inflation will even result in deleveraging. It just gets better and better.

Bernanke looks smarter with each passing day--a little slow to move, but right one when he does.

Dr William J McKibbin said...
This comment has been removed by the author.
Dr William J McKibbin said...

Just read that Janet Yellen, Vice-Chairman of the Federal Reserve, may be posturing for QE3 based on problems in California -- more at:

http://gregor.us/california/california-and-janet-yellen-will-drive-the-next-round-of-qe/

Here we go again -- the Main Street Depression in America is not going to make Federalism easy...

Christian S. Herzeca, Esq. said...

scott

it might be interesting to superimpose a S&P500 graph onto your 2-30 treas. yield spread chart.

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honestcreditguy said...

Benjamin,

Your post is rediculous..Forced inflation is the beginning of the end for the US Govt. and Fed..The stock market helps few people today while causing suffering and hunger along with death for millions of people around the globe..

Dont be such a banker shill...The real economy without fed induced green shoots doesn't end a depression...it only postpones it..

Higher food and gas costs will start the fire this summer...

You love your stocks shows much about your inner core....

greed sleeps with the devil..

Inflation is roaring while you bask in your silly casino winnings...

the house of cards is running out of tricks...soon many will find out how the house was built on sticks....

Benjamin said...

HonestCreditGuy-

Yeah, I love stocks and property, and I want values to zoom up. This is bad?

Yes, moderate inflation would be good for America. We could develerage while fueling growth.

Actually, I think the USA has been innoculated against inflation. We have open borders for labor, goods, services and capital. Solid demand brings the domestic economy up to capacity, and then capacity starts expanding as labor, capital, goods and services flow in.

When 12 million hard-working Latins pour across the southern border, you don't think that dampens wage inflation? When 3 million cars are imported, that doesn't flood car lots? When capital flows in, you don't think that flattens interest rates? When you hire an India call center, those services don;t tamp down service costs?

This is another reason, along with declining unit labor costs and glutted commercial real estate markets, why Bernanke has the field wide open, baby, wiiiiiidddeee open.

Gasoline is set on global markets. We can draw the monetary noose around our necks, and gasoline would still go up. China, India etc. You can bet gold and gasoline is going up in japan too, and they haven been following deflationary policies (with ruinous results).

Really, I do not understand the "tight money is needed" crowd. At the bottom of a recession? When slack is everywhere? When we may have minor deflation?