Friday, April 24, 2009

Yield Curve Steepest Since 11/08

Treasuries could face a test of the Fed's 3% de facto line in the sand for the U.S. 10-year. Whatever the cause, Treasuries have steadily ebbed, with the weakness concentrated on the long end of the yield curve -- the short end is going nowhere because the Fed controls the rates.

The Treasury yield curve is steepening and is at its steepest since the end of November, which has both good and bad connotations. The most important positive is that a steep yield curve typically precedes economic recoveries. Today the spread between three-month T-bills and 10-year T-notes -- the key empirical gauge used in forecasting models -- is 287 basis points, a level that historically has indicated the chances of recession 12 months hence are very small.

For example, in a study by Estrella and Mishkin, a yield spread of more than 121 basis points was associated with just a 5% chance of recession, which makes the current level comforting. For reference, note that the same study showed that a yield spread of -82 basis points (an inverted yield curve) produced 50% odds of a recession. The yield spread was as wide as -60 basis points in February 2007.

Some of the recent steepening of the yield curve reflects the increase in Treasury supply, with the long end of the yield curve bearing the burden. This is the negative side of the steepening.

If the U.S. dollar were to fall, any steepening would take on an even larger negative connotation, but the dollar's decline would have to be significant to have meaningful effect on the yield curve. The negative implication of a significant dollar drop and sharply steeper curve is the message it sends regarding the global appetite for U.S. assets.

Any increase in the cost of capital in the U.S. would complicate efforts to battle the financial and economic crisis.

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