Why the Steepening Yield Curve?

by: thomas e. brewton | published: 06 02, 2009

Investors are beginning to look ahead, anticipating surging inflation.

A reader signing himself AmendmentX posted a comment with a link to Federal Reserve puzzled by yield curve steepening.

As he noted, that supports my statement">my statement that:

As former Fed chairman Alan Greenspan admitted in post-meltdown testimony to Congress, no group of bureaucrats, no matter how intelligent or how well informed, can accurately predict the timing of economic turns or determine the correct theoretical equilibrium rate of interest.

Some readers may not understand that a steepening yield curve (i.e., one in which the spread between short and long term interest rates is a wide one) is generally taken to mean that investors expect rising interest rates. In this case, interest rates are expected to rise because of mounting inflationary pressure, which reduces the present value of future interest and principal payments. Hence investors demand higher interest rates in compensation.

The mechanism is that, when interest rates rise, long-term bonds drop a greater percentage in price than do short-term notes and certificates. Thus, investors expecting rising interest rates swap out of long bonds into short ones, driving up the price (which reduces the yield) of short notes and raises the yield of long ones (because the supply of long bonds becomes greater than the demand, dropping prices and increasing yields).

A few months ago, interest rates were at or below zero on short-term Treasuries, because everyone in the world was seeking the safest available temporary haven to protect the principal value of assets. As recently as last December, 30-year maturity Treasuries yielded only about 2.5%, while tax-exempt municipal bonds were yielding between 4% and 5%, which, after tax, is even higher relative to Treasury yields.

Reflecting the outlook for inflation, 30-year Treasury yields, at last Friday's close, were 4.3%, almost double the level of last December. This, mind you, is in the face of the Fed's expectations that it could keep long-termTreasury yields under 3%.

Rising long-term interest rates increase business costs and inhibit recovery from a recession and act as a drag on expansion of economic activity, which is why the Treasury and the Fed struggle to keep interest rates low. Unfortunately the only way they know to do that is to dump more money into the economy. In the short run that does lower interest rates. But experienced hands in the bond market remember the 1970s stagflation and are now looking ahead to the inflationary surge that will come when business begins to revive and people start to spend all those excess dollars in the economy.

Now that the worst of the financial collapse is passing, investors begin to look ahead to reviving business activity. Given the vast increase in dollars courtesy of the Fed's tripling its balance sheet assets, those investors anticipate surging inflation within the next couple of years and are moving holdings into the short-term end of the yield curve.

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