Thursday, December 24, 2009

Steep Yield Curve Signals What?

Many astute investors follow the shape of the Treasury yield curve for clues as to the future direction of the economy. The yield curve is simply the difference in yield between Treasury securities of various maturities. When it’s steep, meaning that yields on longer-dated securities are higher than yields on shorter-term securities, it’s typically interpreted as a signal of strong future economic growth. On the other hand, when the difference, or spread, is very narrow, or even “inverted” (short-term yields higher than longer-term yields), it’s believed to be warning of an oncoming recession. While seemingly quite simple, the yield curve has proven to be a very reliable indicator over time.

Recently, the 2-Year/10-Year U.S. Treasury yield curve reached its steepest level ever. This means that the difference in yield between 10-year and 2-Year Treasuries grew to its widest margin in history (approximately 2.75%, as shown on the chart below). This seems odd, since the current consensus seems to be that we’re destined for several years of a “New Normal” with lower than average growth potential. So is the consensus just wrong, or is the yield curve signaling something different this time?

One scenario with a growing following has more to do with the latter. With high unemployment and extremely high debt levels, a growing number of economists are becoming increasingly worried about so-called “sovereign default risk,” or the previously unthinkable chance that the U.S. (and other major countries) may not be able to fully meet their ballooning obligations in coming years. Consequently, investors are demanding higher compensation in the form of higher yields on longer-term securities due to the perceived increase in risk, while the Federal Reserve keeps rates on short-term securities artificially low, resulting in the wide spread. In addition to sovereign risk, worries of rising future inflation expectations due to central banks around the world pumping liquidity into the system through all of the various Quantitative Easing strategies may also be pushing yields on longer-term securities higher. Whatever the true reason may be, the record-steep yield curve is just another indicator that we’re watching very closely at this critical juncture.