Monday, April 21, 2008

the yield curve is at its flattest since february

reflecting reduced expectations for future rate cuts, the yield curve is today at its flattest in over two months. the yield spread between two- and 10-year notes is currently at 157 basis points, down 1.5 basis points on the day and its narrowest since 2/1/08. the peak was 208 basis points on 3/6/08, when rate cut fever was reaching its high. odds of a rate cut have fallen sharply since then, such that the market now sees only one more rate cut for the current cycle and rate hikes as early as the end of this year.

the flattening of the curve will have its limits until more-definitive views on rate hikes develop, as the two-year note tends to stay very close to the funds rate.

the two-year is today at 2.19%, which puts it above the 2% funds rate that is expected to be in place next week. the two-year is now 84 basis points above last month's low. now that the two-year is trading closer to the funds rate, the Treasury market is much more fairly valued than it was a few weeks ago when there were unreasonable expectations for the funds rate.

for equities, the flattening of the curve might seem as bad news because it reflects reduced odds of a rate cut. more important, however, is that the reduced rate cut odds herald more optimism about the economic outlook than existed a few weeks ago. it is hence good news for now.

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