Reply #2: Market Observation [View All]

[ozymandius]

The Message of the Yield Curve
BY GARY DORSCH

The yield curve can tell a lot about investors’ expectations for interest rates and whether they predict the economy is going to expand or contract, and also, express its opinion about the direction of the stock market. When short-term interest rates are lower than long-term rates, the yield curve is sloping upwards, and it often precedes a significant economic recovery. In this instance, traders are anticipating a tighter central bank policy in the future, in order to tackle inflationary pressures in the commodity markets and the economy.

Last week, the yield spread between 30-year Treasury bonds and 2-year notes rose to as high as +374-basis points, its highest level ever, signaling that bond traders are expecting a stronger economic recovery in 2010. A year ago, the yield spread was +170-basis points when the Dow Jones Industrials traded 2,000-points lower, near the 8,500-level, as traders sought the safety of government bonds.

The yield spread between 2-year and 10-year notes reached +280-basis points and was last near these levels in 1992 and 2003. In both instances the economy was pulling out of a nasty recession and staged a sustained recovery. However, on both occasions, the Federal Reserve wasn’t bullied by the yield curve traders and waited for about a year before it grudgingly began to hike the federal funds rate.
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The Fed is in no hurry to hike the fed funds rate in the months ahead, pointing to the low capacity utilization rate for factories and mines and the high jobless rate, which in turn is expected to keep inflation in check. However, the message of the yield curve signals a different story, anticipating a stronger economy and the emergence of inflation in the year ahead. Such notions of faster inflation are buttressed by the sharp upturn in the commodity price indexes from levels seen a year ago.

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