The Message of the Yield Curve

by Gary Dorsch, Global Money Trends. December 22, 2009

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.

In a replay of the past Fed officials are telling the bond market today they’re not prepared to tighten money policy anytime soon, even after the US stock market has rallied 62% above its March lows. After its December meeting the Fed repeated its pledge to keep the fed funds rate near zero-percent for “an extended period.” On Dec 21st, Chicago Fed chief Charles Evans said he expects the US jobless rate, currently at 10%, will edge up “a few tenths” of a percent before peaking in the spring or summer of 2010. “To me, that’s about three to four meetings before we’ll recalibrate,” monetary policy, Evans said.

Fed officials are aiming to inflate the value of the stock market sharply higher with a super-easy money policy designed to restore confidence to American households through the so-called “wealth effect.” Yet the Fed is aware that if the bond market vigilantes regain control over long-term interest rates by jacking-up yields to reflect the revival of inflationary fears it could derail the stock market’s recovery. That’s something the infamous “Plunge Protection Team” aims to prevent.

But the Fed’s room for maneuver with its ultra-easy money is narrowing after Chinese central banker Zhu Min warned on Dec 17th that it will become more difficult for Beijing to finance the US-budget deficit. “When the US has to fund its deficit through the combination of issuing more Treasuries and printing more dollars, it is inevitable that the dollar will continue to weaken. The US can’t expect other nations to increase purchases of Treasuries to fund its entire fiscal shortfall,” Zhu said.

Bowing to Beijing’s displeasure over the handling of its monetary affairs, on October 29th the Fed completed its seven-month buying spree of $300-billion of Treasury notes, which had kept bond yields artificially depressed even while the US Treasury sold a record $1.25-trillion in notes. Without the artificial support of the Fed, Treasury yields can climb higher, as the US-government auctions $2.4-trillion of debt in the year since Oct 1st, up from $1.8-trillion in the prior 12-months.

After news of a surprise drop in the US jobless rate to 10%, yield curve traders began to speculate the Fed would hike rates sooner rather than later. But Fed chief Ben “Bubbles” Bernanke said he’s sticking to his pledge to hold rates at zero percent for an extended period. “We still have some ways to go before we can be assured that the recovery will be self-sustaining, and will create the large number of jobs needed to materially bring down the unemployment rate.”

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.

The jump in US Treasury yields has provided extra ammunition to Japan’s ministry of finance whose intervention schemes, designed to bolster the value of the dollar against the yen, has succeeded, at least for now. Since the dollar briefly plunged to a 14-year low of 85-yen on Nov 27th, the dollar has since rebounded to as high as 91.5-yen today, aided by a quarter-point jump in the US Treasury’s 2-year yield to roughly +70-basis points above Japan’s 2-year government yield.

Whereas earlier in the decade Tokyo acted to support the dollar through sterilized intervention in the currency markets; today, Japan’s financial warlords are utilizing the “nuclear option” of central banking – QE, - or printing vast quantities of yen. On Dec 1st, the BoJ injected 10-trillion yen into the Tokyo money market in order to weaken the value of the yen and in turn, boost the Nikkei-225 stock index.

On Dec 21st, BoJ chief Masaaki Shirakawa said the bank will maintain “effective zero interest rates” and is ready to print more yen to beat deflation. “We will patiently maintain the current effective zero interest rates in order to improve supply-demand balance in the economy. What we have to fear the most is a vicious cycle of fall in price and deterioration in the economy. To prevent that, we need to provide ample funds and maintain stability of the financial system. We are always ready to act promptly and decisively if necessary,” Shirakawa warned.

On Dec 22nd, Japan's national strategy minister Naoto Kan said the BoJ had succumbed to heavy political pressure, and would ramp-up its yen printing operations until the national consumer price index rises to the 1-percent level. “The BOJ is basically saying a 1% rise in prices is desirable, and this can be understood as a type of inflation target,” Kan told reporters. “The BOJ’s understanding of price stability shows it will actively take measures to eliminate any perception that it tolerates deflation. The steps the BOJ took at its extra meeting this month show it is working in tandem with the government,” he said.

One of the consequences of the BoJ’s radical policy of printing massive quantities of yen, in order to engineer a devaluation of the yen, is higher long-term bond yields. The yield spread between Japan’s 20-year and 2-year notes widened to +197-basis points last week, with Japan’s public debt nearing 200% of GDP this year. Japan’s finance minister Hirohisa Fujii said on Dec 8th that new government bond issuance will hit a record 53-trillion yen ($593 billion) in the year to March.

Ahead of an election for parliament’s upper house in mid-2010, Japan’s new prime minister is determined to keep the pressure on the BoJ to buy more government bonds to keep a lid on market interest rates. That’s helped to boost the Tokyo gold market towards the psychological 100,000-yen level.

Gary Dorsch

© 2009 Gary Dorsch

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