Monday, February 28, 2011

Thoughts on the yield curve

These charts tell the long-term story of Treasury yields. Yields today are very low by historical standards, but the yield curve is almost as steep as it's ever been. Yields today are low because inflation is low, and because the Fed—and the bond market—are very concerned about the health of the economy and the risk that a lot of economic "slack" might produce deflationary pressures.

To avoid deflation and to give the economy a boost, the Fed has promised to keep short-term interest rates very low for a long time. The market currently expects the Fed funds rate to remain at 0.25% for at least the rest of this year. Since the yield on 10-yr Treasuries is driven in large part by the expected future path of short-term rates (i.e., the current 10-yr yield of 3.4% implies that the Fed funds rate will average 3.4% over the next 10 years, with the funds rate projected to rise to about 4.25% within 10 years), the Fed's promise to keep short-term rates low for an extended period is putting downward pressure on 2- and 10-yr Treasury yields. But the 10-yr yield is not completely constrained by the Fed's promises—if the bond market were convinced that the Fed was making a big mistake by keeping short-term yields low-for-long, then it would be free to jack up future expected rates.

Regardless, it would appear that 10-yr yields of 3.4% today are fairly valued if inflation stays in a 1-2% range. In other words, there is no evidence here that the fed has grossly distorted the yield on Treasury notes or bonds, since they currently yield about 2% more than inflation, and that is in line with historical observations. And the almost-unprecedented steepness of the 2-10 curve suggests that the market is not giving the Fed much benefit of the doubt: the amount of eventual tightening that is priced in is also almost without precedent. I take this as evidence that the Fed is not unduly distorting yields, and that it is guiding policy more or less in line with current market thinking. Long-time Fed-watchers know that the Fed and the bond market are always engaged in an intricate and complicated dance, where one leads the other and vice-versa. The feedback goes in both directions, and there is no sign that anything is obviously amiss right now.

But if inflation rises and/or the Fed decides to raise rates sooner than expected because the economy is exceeding expectations, then 10-yr Treasury yields will face inexorable pressure to rise. That is the big "if" that is hanging over markets today.

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