A Normal Yield Curve Isn’t Always a Good Thing

Perhaps I’m in a jaded frame of mind. but today is one of those days where the news items don’t strike me as all that compelling. There are days where there really isn’t much new in the news (and juicy byplay is wanting as well).

In the early 1990s, I was in Bali for six weeks. I wasn’t seeking to be plugged in (and in those days it would have been difficult), so my main source of information as to what was up in the wider world was the cover of Newsweek. One week it was the Whitewater scandals. That had been in motion before I left the US, so I knew there was no real news that week. The next week, it was the meltdown of the peso. Well, Mexico, at least in those days, was widely known to have a fragile economy, so that didn’t qualify as news. The week after that featured Las Vegas as an up-and-coming city. I knew there was really no news that week.

Nevertheless, the Financial Times’ today gives a contrary view to a recent theme in the US business press: that the changing shape of the yield curve, which may be in process from being inverted to normal, might not be a positive development. Lex argues that if the recent uptick in inflation persists, the Fed is in a difficult position, since it will have to worry about both slower growth and inflation. The column mentions stagflation as a possiblity, as did the Wall Street Journal (and we did earlier).

What is the yield curve telling us? Having been largely inverted for seven months it regained a more normal upwards slope on March 21, on the day of the Federal Reserve’s latest statement. The trouble is, the dis-inversion appears due to economic worries rather than clear skies ahead.

On February 21, 10-year Treasuries yielded 15 basis points less than two-year debt. But as investors have moved to factor in interest rate cuts affecting the short end, the curve has steepened, with 10-year Treasuries now yielding five basis points more.

Despite Ben Bernanke’s claim that the Fed still has an implicit “tightening bias”, he has acknowledged that the risks to economic growth have increased. Meanwhile, inflation remains a serious concern. The most recent core personal consumption expenditures deflator rose by 2.4 per cent year on year, way above the 1-2 per cent “comfort zone”. With inflation a bigger risk for longer-dated Treasuries, the 10-year yield has been kept up, steepening the curve.

One hope is that the recent bout of high inflation is a spring scare, as in recent years, and that it will back off as important components such as housing and medical costs subside. But, if not, the Fed could be in a sticky bind. With many financial products, such as mortgages and corporate bonds priced off the long end, a rise there tightens financial conditions and acts as a brake on growth. If growth becomes a real problem, the Fed may even have to cut short rates more to have the same stimulative impact. And there is the potential Catch-22 situation of rate cuts against an inflationary backdrop actually fuelling concerns at the long end. The US remains some way from stagflation. But the bond markets may be starting to price in a tougher road ahead for the Fed as it tries to balance the twin risks of growth and inflation.

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