Thursday, May 28, 2009

If We Build (Yield Curve), Will They (Economic Expansion) Come?

A steeper yield curve is supposed to indicate a beginning of economic expansion. But after all the Fed intervention in Treasuries which is by the way set to further increase, is the shape of the yield curve still an indicator of anything at all?

Here's the Treasury yield curves from three different time period. Data was taken from the US Treasury Department website. The red line is yesterday's yield curve. The blue line is the yield curve from December 2008, after the Fed announced quantitative easing. The orange line hovering above is from April 2007, when the stock market, having recovered from a dip in February, was merrily going up on its way to October 07 top.

The current yield curve is indeed steep. Does that mean the economy will expand? (What part of the economy? Government?) Or does it simply mean that there is just too much supply of Treasuries across the curve, and the Treasuries that the buyers (domestic or foreign) are willing to buy are shorter-term Treasuries only (and they are basically rolling over)? The Fed is buying longer-term Treasuries to keep the rates down, but the sheer size of the market doesn't quite match the Fed's pledged amount ($300 billion). So what happens? There are more sellers than buyers for longer-term Treasuries, prices go down, yields go up.

It is, however, the Fed's stated policy to support the lower long-term rates to help the economy. They are increasingly losing control and the yields are going up. Hence the spin: higher yields indicate things are improving.

Perception is everything in this time of great difficulty. To me, it is more like "If you contort your face into a smile, you will feel happy."


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