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.

Comments

[Pink Panther:]

Insightful article!
Let's hope 'Copter Ben reads it too.

May 27 06:26 AM

[xxxx:]

Please define recovery. I do not consider a recovery something that eats away my savings every day while the banks get money for free. In fact this policy by far hurts the majority of american's and makes their lives worse

May 27 10:52 AM

[InnocentsAb...:]

Perhaps changing the term to "recovery in the value of industrial equity" would be more accurate. IMHO, small capitalization and technology equities are going to be relatively strong, perhaps very strong.

On May 27 10:52 AM xxxx wrote:

> Please define recovery. I do not consider a recovery something that
> eats away my savings every day while the banks get money for free.
> In fact this policy by far hurts the majority of american's and makes
> their lives worse

May 27 12:33 PM

[e1618978:]

I think that TBT will be good in the long run, but we could have another "flight to quality" that drives treasury yields down in the mean time, triggered by GM bankruptcy chaos.

May 27 03:04 PM

[LKofScotland:]

ahh if only it was as simple as borrowing short to lend long. that pre-supposes the paper has any value whatsoever and that the paper to whom you are lending can be repaid. while the Laffer curve has actually been proven under W to be real (witness the real rise in tax receipts after a tax cut) what now is being proven as it has before is Gresham's law, namely, never throw good money after bad. i'll wait to see if the earnings for these "winning banks" has any relevance to their stock price especially given the tremendous run-up in the stock prices of the likes of BofA and Wells Fargo. Both piles of junk if you ask me. As for the rest of corporate America--this is what makes inflation so insidious--you just don't know the economic value of earnings in here because the earnings are in "dollars" which right now appear relatively worthless. Add a recession and the collapse of the ability of state and local governments to roll over their massive debts in the commerical paper market (remember that collapse?) and you have some impossible hills to climb for corporate america. just too many productive Americans have to be thrown overboard in order to keep the ship from sinking. don't get me wrong--there have ALREADY been huge winners in this epochal collapse of Wall Street. But until the bubble that is the treasury market which has now burst is reined in by the Fed all bets are off for equities. Yield demanding investors are on the war path and until the "quality" names are getting charged 12% or thereabouts (insurance companies come to mind) i don't think any investor is being compensated properly for their risk in this environment. Outside of trying to corner to bond market here i'd be lightening my own load in here and raising cash. on the other hand trying to corner uncle sam's treasury market would be a very tempting game to ante-up in.

May 28 05:27 AM