Steep Yield Curve

The yield curve is at its steepest on record (via Bloomberg):

May 27 (Bloomberg) — The difference in yields between Treasury two- and 10-year notes widened to a record on concern surging sales of U.S. debt will overwhelm the Federal Reserve’s efforts to keep borrowing costs low.

The so-called yield curve steepened to 2.75 percentage points, surpassing the previous record of 2.74 percentage points set on Aug. 13, 2003. Yields on 10-year notes have risen more than 100 basis points since Fed officials said in March they would buy up to $300 billion of U.S. debt over six months to drive consumer rates down and lift the economy from recession.

Many have pointed to this curve steepening as a negative response to increasing supply, but it can also be interpreted as a positive sign. A steep yield curve typically precedes an economic recovery. Part of the reason for that is that a steep yield curve is very profitable for banks and as their profits increase they are more likely to lend. And the steeper the curve, generally, the stronger the recovery.

And at least some of the selling has nothing to do with either economic recovery or fear of deficits:

Rising 10-year Treasury yields are pushing yields on mortgage bonds higher, prompting holders of the securities to sell government debt used as a hedge to protect portfolios against rising interest rates.

As mortgage rates rise, the expected average lives of mortgage bonds and mortgage-servicing contacts extend as potential refinancing drops, leaving holders with portfolios of longer-than-anticipated durations. Duration is a measure of bond price sensitivity to interest-rate change.

“The back-up is mostly related to convexity selling by mortgage investors,” said Gary Pollack, who helps oversee $12 billion as head of fixed-income trading at Deutsche Bank AG’s Private Wealth Management unit in New York. “This will be a test for the Fed.”

The problem is that convexity selling begets more convexity selling and the Treasury market overshoots which is what we are going through right now.

Arnold Kling points out that this is what should be expected from Keynesian stimulus:

In my view, this is perfectly rational, and it shows that the short-run effect of the fiscal stimulus is negative, as Jeff Sachs predicted.

This is all based on a Keynesian type of macro analysis. As we know, most of the stimulus spending does not take place until next year and beyond, so the short-run gains are puny. On the other hand, the big increase in the projected deficit creates the expectation of higher interest rates, which raises interest rates now. These higher interest rates serve to weaken the economy.

According to this standard analysis, the stimulus is going to hurt GDP now, when we could use the most help. Much of the spending will kick in a year or more from now, with multiplier effects following afterward, when the economy will need little, if any, stimulus.

This is the flaw with using spending rather than tax cuts as a stimulus. The lags are longer when you use spending.

Of course, if the real goal is to promote government at the expense of civil society and to create a one-party state in which business success is based on political favoritism, then the stimulus is working exactly as intended.

Brad Setser explains it in terms of supply and demand from Central banks who are reducing the maturity schedule of their holdings:

Over the last 12 months of data (data through the end of April, May data will be out soon), the US issued $735 billion of notes, bonds and TIPs.* In calendar 2008, the increase in supply of longer-term Treasuries was about $400b – a large sum, but easily within the realm of historical experience.

Yet even as the supply of notes has increased, central bank for longer-term Treasuries for their reserves has fallen. Central bank demand for longer-term Treasuries – on a rolling 12m basis – has been trending down since August 2008.

Setser has some very interesting graphs on supply and demand for Treasuries, so by all means read the whole post.

Obviously all of these factors played a part in the selloff in the long end of the curve. Should we be worried about it? Well, it certainly shows just how impotent the Fed is in trying to create growth by printing money. The more they print to buy Treasuries, the more likely it is that the Central banks (particularly China) will pass on buying long term bonds as their worry about the US dollar increases. And as demand in the long end of the curve wanes, long term interest rates rise, potentially choking off the recovery the purchases were intended to create. Bernanke has painted the Fed into a corner. If he announces that he will ramp up Treasury buying with newly created money (quantitative easing) he’ll scare the inflation hawks. If he ends the purchases, investors will fear a further loss of demand.

Government efforts to “stimulate” the economy are doomed to fail. The Fed’s actions, coupled with the profligate spending of Congress, will likely only result in higher inflation. There will be a period of time where GDP rises before the inflation shows up in the CPI, but it is unlikely to be sustained. In the short term, I think the yield curve is signaling recovery; Fed monetary inflation will create economic activity, even if it is not sustainable, efficient activity.

In the long run though, growth cannot be created with a printing press. Growth, real growth, will  only come when the US gets its fiscal house in order and provides investors with sufficient incentives to save and invest. The efforts of the government to stimulate consumption in the absence of prior saving and investment amounts to eating our seed corn.

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