Yield Curve Steepens / Hoenig Hawkish

A: Amazing how things change. Remember late 2006 all the talk about the bond market and the inverted yield curve predicting a coming slowdown in the economy; forcing the fed to eventually cut rates? Well, the fed did so about 10 months later and cut the FFR by 325 basis points to stimulate the economy and credit markets. Now, the yield curve is steepening again and Kansas City Fed President Thomas Hoenig may have something to do with it.

First, some econ 101 about a steepening yield curve:

Steep Yield Curve: Historically, the 20-year Treasury bond yield has averaged approximately two percentage points above that of three-month Treasury bills. In situations when this gap increases (e.g. 20-year Treasury yield rises relatively higher than the three-month Treasury yield), the economy is expected to improve quickly in the future. This type of curve can be seen at the beginning of an economic expansion (or after the end of a recession). Here, economic stagnation will have depressed short-term interest rates; however, rates begin to rise once the demand for capital is re-established by growing economic activity. A steep yield curve is generally a bullish indicator.

StockCharts.com has a great little Dynamic Yield Curve tool that time lapses the yield curve with the S&P 500 Index since 2000! By hitting animate, the yield curve tool will dynamically change as time goes on, and you can see what equities did as the yield curve flattened, inverted, and steepened! Current yield curve snapshot to the right.

The yield curve is not a perfect indicator, so don't go betting your $$$ on it so fast. I have my doubts about the recession ending so soon and a new economic boom coming; in my opinion, the steepening yield curve is pricing in future inflation concerns and not a new economic boom! I'll go on record for that one, as I am still cautious about the strength of the consumer given a tight credit market, correcting housing market, limited equity for withdrawal (spending) from homes, and irresponsible use of debt/leverage for so many years. In short, I just think the consumer is tapped out and this is not something that turns around so fast; lets not forget that 70% of the US economy is driven by the consumer and the reason why the Bush stimulus package was passed to give Americans more money to spend!

However, as someone who loves to learn and understand 'why' things happen the way they do, it's hard to ignore what is going on in the bond market. It signifies a few things:

a) heightened inflation expectations/concerns
b) rates expected to rise in medium term
c) US dollar support
d) economic slowdown/recession expected to be mild

Whether or not this turns out to be the case is the $64,000 question! Future economic data will certainly drive the yield curve over the next few months; if economic data deteriorates, you will see the yield curve flatten (long end come down more drastically than short end flattening the curve) signaling the fed may need to cut rates a bit further to stimulate the economy. In this case, the US dollar will likely fall further and commodities priced in US dollars will rise further, creating more pipeline inflation pressures.

Hoenig's statement is interesting because it has to do with INFLATION EXPECTATIONS! The psychology of living in a world of rising costs/prices may force businesses and consumers to alter their investment/spending patterns! Businesses will get cautious and look to cut costs to retain profits while consumers will cutback on spending and perhaps even save a bit to afford the higher costs of living.

According to Bloomberg:

The dollar strengthened versus the euro as Hoenig of the Kansas City Fed said in a speech in Denver yesterday that "serious" inflation pressure in the U.S. may compel the central bank to increase interest rates.

"There is a significant risk that higher inflation will become embedded in the economy and require significant monetary policy tightening to reduce it," said Hoenig, who isn't a voting member of the Federal Open Market Committee this year. Consumers are gaining an "inflation psychology to an extent that I have not seen since the 1970s and early 1980s."

The reference to the 1970's and 1980's is when fed chief Volcker had to raise rates to insanely high levels to give the nation the inflation medicine it needed to fight the disease of 'the worst tax of them all'.

Below is a chart that Hoenig refers to in discussing the rise of inflation expectation (Federal Reserve Bank of St. Louis via Calculated Risk)

As I said April 15th, by talking tough on inflation we can remove the speculative currency trade in commodities and ease pipeline inflation pressures without action at this point. Thing is, commodity inflation is similar to fed rate cuts; it takes time to funnel through the system! So, $120 oil today, will have a lagging effect on corporate profits down the road! I can see it already!

2009 Fight of the Year: Inflation vs Economic Recovery

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