The Steepening Of The Yield Curve: Is The Federal Reserve Behind This Too?

by: John M. Mason

Summary

Not only have the yields on Treasury securities risen over the past nine days but the Treasury yield curve has also become steeper.

The indications are that this increase may be the result of foreign money leaving the US bond market much the way they did in the latter part of 2012.

This time, however, money may be leaving the bond market because of the financial market volatility caused by the erratic way the Federal Reserve is managing monetary policy.

Yesterday, I wrote about rising bond yields and what seemed to be happening in that market. Today, I want to address the increase in the yield curve. The Treasury yield has been increasing for the past nine days.

Eliza Ronalds-Hannon writes in Bloomberg that the "Yield curve steepens as traders trim bets on higher Fed rates…Bonds trail on dimmed speculation central banks to keep buying."

"The $13.6 trillion Treasury market is sending a signal it hasn't flashed in more than four years."

The message: "Shorter-dated debt is the place to be as traders gain confidence the Federal Reserve will keep interest rates on hold, at least through next week's policy meeting. The extra yield investors demand to own 30-year rather than five-year securities, a measure of the yield curve, increased for a ninth straight day Wednesday. That's the longest streak since 2012, data compiled by Bloomberg show."

The reasons: "Traders are favoring shorter maturities as a Fed on hold is seen as potentially stoking inflation, which erodes the value of debt maturing decades in the future. There's another reason those maturities are lagging behind: international central banks are showing reluctance to extend the expansionary monetary policies that drove yields in Europe and Asia to record lows and stoked demand for long bonds in the U.S., too."

I would like to take issue with Ms. Ronalds-Hannon. The reason being that during this nine-day period that the Treasury yield curve steepened, the inflationary expectations built into market interest rates remained roughly constant.

If one looks at the spread in the yield between the nominal interest rate on Treasury securities, say, of a 10-year maturity, and the same maturity yield on the Treasury's Inflation Protected securities, one sees that the inflationary expectations remained right around 1.50 percent for the full nine-day period.

This is true of inflationary expectations in the 5-year maturity range and the 30-year maturity range. There is no indication that investors in the bond market went through a change in their view of inflation during this period. In terms of the second factor she suggests, the backing-off of international central banks, I would like to contest this point too.

The beginning of the rise in United States interest rates and the steepening of the yield curve in the Treasury bond market, I would like to present the fact that nine days ago, the yield on the TIPS turned upward with the interest rate on the 10-year TIPS turning from just around zero to a close yesterday of 18 basis points.

The 5-year TIPS yield seemed to bottom out - in negative territory - for the first time since it turned negative in early March of this year.

I bring this information forward because Ms. Ronalds-Hannon compares the current period to the period in August 2012. It just so happens that it was around August 2012 that the yields on the 5-year TIPS and the 10-year TIPS seemed to bottom out and begin to move back toward positive territory.

The reading in the market at that time was that the flow of risk-averse money coming into the United States looking for a "safe haven" for investment seemed to have slowed down or stopped. And, in the following months, these monies began to move back offshore to other venues. That is, the flow of risk-averse funds began to reverse itself.

In terms of the current situation, this is the picture I drew in the post I wrote yesterday.

The fact that I believe supports this argument is that the yields on both the short-term Treasury securities and the longer-term Treasury securities have risen during the past nine days. The yield curve steepened because the longer-term rates rose by more than the shorter-term rates.

If the hypothesis of Ms. Ronalds-Hannon were correct, I believe that you would have seen the yields on the shorter-term securities fall, while the yields on the longer-term securities rose. Since, the whole yield curve rose, I think that you have to look elsewhere for an answer.

The conclusion from this is that international funds have left the US Treasury market over the past nine days or so, with the movement causing longer-term yields to rise more than shorter-term yields did.

The move may have been caused by the stock market volatility of the past nine days or so.

On September 6, around when all this started, the Dow-Jones Industrial Average was around its historic high, the S&P 500 stock index was around its historic high, and the NASDAQ index set a new historic high on September 7.

Since then, these indexes have bounced all over the place.

The hypothesis here is that the volatility of the United States financial markets caused some of the "safe haven" monies to leave the United States. The cause of this "leaving" is the erratic behavior of the Federal Reserve.

If this is true, then we are just seeing another situation in which an out-of-touch Fed is upsetting the US financial system.

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.