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Curve Shape and Fed Policy

|Includes: IEF, IEI, iShares 1-3 Year Treasury Bond ETF (SHY), TLT

 Curve steepness (2s to 10s spread) is down off its record high of 2.91%, and is currently 2.72%. The story has been pretty constant here. The Fed has a chokehold on the short end by assuring the market that the Fed Funds target rate isn’t moving any time soon, and despite effectively cornering the market for longer term Treasury bonds, their influence isn’t what it was in the early days of QE2. Recent inflation readings and better risk appetites worldwide have added to the pressure on longer-term rates.

 

So where does the curve go from here?

 

Fed Officials are diverging more and more as economic data improves and pressure to reverse policy increases. The not so united FOMC is changing from the days of Thomas “The Lone Dissenter” Hoenig, to being more split down the middle. Despite losing Hoenig, a hawk who typically favored tighter monetary policy, current voting members and fellow hawks Fisher, Kotcherlakota and Plosser are making themselves heard in the media while arguing for tighter policy from the Fed.

 

If the Fed decides to maintain the size of the balance sheet after QE2 ends in June, and bring Fed Funds up to 1% or so, the curve would probably flatten from its current levels. Both sides of the yield curve would head higher in this scenario, but the move would probably be more exaggerated in the short end.

 

However, if the Fed concentrated more on unwinding their balance sheet instead of normalizing short-term rates, the short end would continue to be anchored near zero and the longer end would lose its biggest buyer resulting in an even steeper yield curve than now.

 

It’s important to remember that we have been here before. This time last year, the curve had steepened to record levels and most of the market was anticipating a change in policy from the Fed. When economic growth stalled in the summer, and deflationary concerns returned, the Fed stepped in and implemented QE2. The economy is stronger now compared to early 2010, but weakness related to higher energy prices and issues spreading from Japan is moving economist to pare back their growth estimates for the first quarter and may give more dovish FOMC voters ammo for their upcoming meetings.

 

Even though signals from the Fed are pointing toward tighter policy after QE2 is completed, it is by no means a sure thing. A downturn similar to what we had in the middle of last year would all but guarantee a QE3 in my opinion, and until the Fed is sure we are free from such a reversal, current policy is here to stay.

 
Have a great weekend.

 

Cliff J. Reynolds Jr., Investment Analyst