Tuesday, December 22, 2009

Yield Curve, Investor Optimism at Record High

WSJ -- A closely watched bond-market measure of investor optimism hit a record Monday, amid signs the U.S. economy's recovery is strengthening. That measure is the yield curve -- the difference between short-term and long-term interest rates on government bonds. That number is at its highest level ever, surpassing the record set in June, and signals that investors are expecting a stronger economic turnaround ahead.

The interest-rate development is good news for banks, which normally borrow at short-term rates and lend at long-term rates. The bigger the difference, all else being equal, the bigger their profit. Higher profits mean banks can refill their coffers, which have been drained by bad debts, and return to health.

The yield curve steepens when the Federal Reserve, which controls short-term interest rates, keeps them low to spur the economy. But at the same time investors, expecting growth to resume and with it the possibility of inflation, sell longer-term government bonds, which sends their prices down and their yields up. The difference between the yields, in this case on 2-year and 10-year notes, is the main gauge of the yield curve. On Monday, the difference reached 2.81 percentage points (see chart above). The gap between short- and long-term yields tends to stretch on the way out of economic trouble.

Before this year, the yield curve was last near these levels in 1992 and 2003. In both instances, the economy was pulling out of a recession, and staged a sustained recovery. However, on both occasions it took a year or more before the Federal Reserve decided the economy was strong enough to warrant interest rate increases. At this time last year, the gap was 1.27 percentage points. At the crisis onset, in June 2007, the yield curve was inverted: a phenomenon in which short-term yields are higher than long-term ones, a development which often augurs a recession.


At 12/22/2009 10:09 AM, Anonymous Junkyard_hawg1985 said...

Wouldn't a very steep yield curve also be indicative of a fear of future inflation? People are willing to loan the government money for the short term at very low interest rates (3-mo at 0.01%), yet require far more interest to loan for a longer time period. A fear of future inflation would support a steep yield curve.

At 12/22/2009 1:04 PM, Anonymous gettingrational said...

If the yield curve goes up then interest rates will follow, right? PIMCO, has changed from negative 7%cash to positive 7% cash in its holdings. Thus, they are predicting higher rates.

At 12/25/2009 10:55 PM, Anonymous Anonymous said...

Relative same question as Junkyard.
What if the "hot" money (cheap u.s. $) flows are just not interested with having any involvement with the longer dated
government stuff. This too, would
put pressure on higher yield numbers, but would not indicate a pure economic recovery.
Your thoughts?


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