Yield Curve: Green-Shoot? Weed?

The yield curve has recently become extremely steep. While there are many ways to measure the curve, the graph below is based on comparing the 10-year T-note with the one-year bill.

The conventional way to measure the curve is to look at the difference between the long-term and short-term rate. I have always felt that this method, while useful, does not tell the whole story, since it does not reflect the overall level of interest rates. After all, long-term rates were at 10.93% in August of 1980 while short-term rates were 9.71%, for a spread of 1.22%.  Almost identical spreads were recorded in January 1991, April of 2001 and March of 2005. However, in 2005, long-term rates were only 4.59%.

I would argue that the yield curve was much flatter in 1980 than in 2005. Therefore I have also included the ratio of long rates to short rates. Keep in mind that for the spread, a flat curve is 0.0, while for the ratio it is 1.0.

On a spread basis, the curve is very steep at 3.10%, but it is not unprecedented. It has been above 3.0% in 2.5% of the weeks since 1962, and above 2.0 in 15.6% of the weeks. It has averaged 0.86% over the period.

However, on a ratio basis we are simply off the charts here. We are now at a ratio of 7.32, while it averages 1.31. Until very recently, the highest the ratio had ever reached before is 3.70 in July 2003.

I don’t have recession bars in the graph, but generally a steep yield curve is associated with an improving economy, while an inverted yield curve is one of the absolutely best predictors of an upcoming recession (but often returning to positive slopes before the recession actually hits).

Is the steep yield curve a green shoot?  Yes, but there may be more than that going on. The Chinese have started to change their portfolio. They have already dumped their agency paper and have been shortening up the duration of their Treasury portfolio.

A steep curve would also be consistent with market fears of potential deflation in the near term followed by higher inflation later. The Fed has been fighting deflation with a vengeance, pumping in unprecedented amounts of liquidity, and resorting to many unconventional means of doing so, with an alphabet soup of liquidity plans (e.g. TALF) and actually engaging in quantitative easing.

They appear to have been successful in their fight so far, but at the cost of a huge increase in the Fed balance sheet and the monetary base as shown below. If indeed “inflation is always and everywhere a monetary phenomenon” as Milton Friedman famously said, then fears of higher inflation down the road are very well founded.

However, in the meantime, a very steep yield curve is a big and underappreciated factor in the bailing out of the banks. After all, the economic function of banks is to borrow short and lend long. Banks like Wells Fargo (WFC: 24.13 0.00 0.00%) and BB&T (BBT: 21.65 0.00 0.00%) must be liking the current shape of the curve. However, if it is pointing to higher inflation down the road, this “green shoot” will turn out to be a very nasty weed.