Friday, July 24, 2009

Yield curve update

The yield curve has steepened of late, and once again it is back to the steepest levels that we have ever seen. That's remarkable in itself, but it's noteworthy that the second half of this steepening episode—which started at the beginning of this year—has been mostly driven by rising bond yields, whereas all others were driven mostly by falling short-term rates.

That tells us that the Fed has been exceptionally and proactively accommodative during this recession, more so than during other recessions. If the steepness of the curve is a measure of how easy money is, then monetary policy is unquestionably very accommodative. It also tells us that with all this monetary stimulus, the economy is very likely to pull out of the recession. Indeed, I think a recovery is already underway. A steep curve is very good for the financial sector, since banks can borrow at a very low interest rate and lend out along the curve and earn a spread. Credit may still be difficult for some to obtain, but not because it's not available. It's because the banking sector has had to regroup after taking huge hits, and traditional sources of lending have in many cases been shut down by the crisis and by the knee-jerk reaction of politicians trying to step up regulatory efforts. But with time this problem will disappear, and the rise in home sales activity all across the country is a good sign that this is already happening. The corporate bond market is reviving as well.

With no shortage of money and a Fed hell-bent on seeing the economy recovery, you don't want to be pessimistic. The Fed always gets what it wants. The only problem is that this time they may get more than what they want, in the form of higher inflation. But for now that remains a problem for later this year or next year. The important thing today is that things are turning up.

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