By Eric Bush, CFA - Gavekal Capital Blog
The yield spread between 10-year treasuries and 3-month T-bills has quietly moved from nearly a 4-year low of 137 bps on February 11th to 162 bps as of yesterday. However, based on the Fed's balance sheet, it seems to us that the front-end of the US yield curve could easily steepen by another 40 bps or so assuming the Fed doesn't begin to reduce its balance sheet (which they have given zero indication of doing anytime soon) . Given that the 3-month yield is currently at 30 bps, or the bottom of the Fed's 25-50 bps target range, we would expect the steepening to occur due to a back-up in 10-year yields. This suggests that a 2.3% 10-year treasury yield is in play.
We have already seen a slight steepening in the back-end of the curve. The yield spread between 30-year treasuries and 10-year treasuries hit its lowest level since 2009 on 3/19/2015. The spread between the two was just 55 bps. The trend since then has been somewhat volatile but the 30-year to 10-year spread now sits at 80 bps. If the front-end of the curve steepens, there is a pretty good chance that the back-end of the curve steepens as well. The 30-year/10-year spread has had a 68% correlation to the 10-year/3-month spread over the past decade.
In the first two charts, we plot the 3-month change in the Fed's balance sheet against the front-end of the yield curve and the back-end of the yield curve. In the last chart below, we show the relationship between the two parts of the yield curve over the past decade.