Why the U.S. Treasury Yield Curve Should Get Even Steeper

by: Kehong Wen

The yield spread between 10-year and 2-year Treasury notes has widened to record levels. In other words, the yield curve has never been so steep for a long, long time. When it is steep, it is predicting future economic growth, usually. Could this time be different? Will it get even steeper?

There are many implications from the steep yield curve. Banks are obviously benefiting from it. As are hedge funds who have access to low interest funding sources. Savers and retirees who depend on fixed income, however, are out of luck.

To fund deficit spending, the government may need to offer higher yields to investors. On the other hand, some investors seem to find it already attractive to own long bonds, helping the Treasury to raise billions of dollars.

The Fed's easy money policy and massive federal spending, however, argues for the possibility of an even steeper yield curve.

The Fed is determined to keep the interest rate at the short end near zero for an extended period. Inflation is not yet a concern because capacity utilization is still very low and unemployment rate is still very high. In fact, it is conceivable that the Fed is determined to wait until it succeeds at creating inflation. Inflation will get the economy going, and it will help get the U.S. out from under its debt burden. Moreover, a weak dollar policy also helps to ease the trade deficit.

So for at least 2010, the short end will continue to be anchored down at zero. The long end will depend on two things: (a) investors' expectation of economic growth and (b) inflation.

People talk about these two factors as if they're independent. We think they're intertwined. Higher growth brings about higher level of economic activities, which means higher velocity of money. That's inflationary. On the other hand, higher prices will help jump start business activities by increasing investment and employment. That will help generate growth.

Now throw in the desire of major external Treasury investors to diversify away from their massive holdings; the odds are we'll see an even steeper yield curve.

Disclosure: No position