The Steepening Yield Curve: Economic Optimism, Or Something Else?

Dec.21.10 | About: iPath U.S. (STPP)

A closely-watched gauge in the Treasury-bond market is signaling that the U.S. economy may gain more traction. The spread between shorter- and longer-maturity U.S. government-bond yields has widened to near a record high as longer-dated yields rise on expectations that inflation pressures will revive.

The common theory is that when yield spreads widen, which is when the so-called yield curve steepens, it suggests investors are optimistic about the strength of the economy. They are demanding higher yields in longer-dated T-bills than in shorter-dated ones in order to compensate for the risk of inflation, which is a main threat to bonds' fixed returns over time.

In a Wall Street Journal article, Min Zeng writes:

When yield spreads widen, banks are the big winners because the lower short-dated yields mean they can borrow cheaply to fund short-term obligations while lending out to businesses and consumers at higher rates.
Higher long-dated Treasury yields also help pension funds and insurance companies cover their long-term obligations. The flip side is that higher yields push up mortgage rates. Homeowners' mortgage rates tend to track the 10-year Treasury yield, and higher rates hurt the already-struggling housing market. It also gets more expensive for companies to borrow in capital markets.

A couple of alternative or additional explanations:
  • The selloff in long bonds corresponded with the passage of the tax cut extension. While they may spur growth, the tax cuts will almost certainly increase the deficit (sorry Mr. Laffer, I'm not a believer in your curve). After all, the tax cut is really Keynesian; it is deficit spending or has the same effect, perhaps more efficiently than a stimulus plan -- or perhaps not.
  • So perhaps the bond vigilantes of the Clinton era are back, fearing more supply coming on the market and pushing down prices and raising yields. This is probably a mixed blessing; remember that the bond vigilantes pushed the administration to close the budget deficit. The treasury stopped issuing long-term bonds during that period (no need to fund a large deficit) and rates fell.
  • The large retail flows into bonds came from investors who were apparently unaware that it is quite easy to lose money in bonds -- particularly in the longer maturities. I wouldn"t rule out large outflows from the funds pushing bond prices down.
  • By contrast, the natural buyers of bonds -- pensions, endowments and insurance companies, who constantly have new inflows -- look at higher rates as a welcome respite, since the higher rates make it easier to meet their future obligations,
  • The other group to have a natural benefit from a steep yield curve is the one that borrows short (deposits and CDs) and lends long with mortgages. Of course, the higher mortgage rates are likely to slow down, whatever recovery exists in the real estate market.
  • While retail investors likely got burned with rising long-term rates, corporations were playing the low long-term rates correctly. Those that issued long-term bonds throughout the year benefited from record low rates. Unfortunately for the economy, they have been using the cash for stock buybacks and dividends -- not job-creating investments.

Of all the arguments for the yield steepening, I find the inflation argument the weakest. First off, I have faith that signs of economic growth will be swiftly met with contractionry monetary policy.

Mr. Market has expressed an increase in inflation expectations . This can be seen in terms of the TIPS/Conventional Treasuries, which don't indicate a particularly strong forecast of inflation The real yiield on the 10-year tip moved up this month from 0.83% to 1.05%, which puts the implied inflation forecast for the next 10 years of 2.83% within the Fed's target inflation rate -- but is still quite a good-sized move from 2.12% at the beginning of the month.

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