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U.S. yield curve signals nagging Fed anxiety
November 20, 2009 / 3:59 PM / 8 years ago

U.S. yield curve signals nagging Fed anxiety

By Richard Leong - Analysis

NEW YORK (Reuters) - A deep-seated anxiety about how soon the Federal Reserve will raise rates has caused the widest chasm between short- and long-dated Treasury yields in 20 years, despite the Fed’s assurances low rates will stay for some time.

If this wide gap persists, it will lend credence to the notion of a sluggish U.S. economic recovery, as banks and money managers refrain from lending and investing.

This lack of commitment from the banks and financial managers will increasingly stymie Fed policy-makers, who are looking to map out a strategy to wind down the emergency measures to combat last year’s credit crisis.

The U.S. yield curve, expressed by the difference between the two-year Treasury notes and 10-year debt, is well above its long-term averages.

This would normally be viewed in a positive light as a “steep” yield curve -- higher yields on longer maturity Treasuries than their shorter-dated issues -- usually signals market expectations of steady economic growth and an environment where banks can lend profitably.

Under the current near-zero rate regime, however, this unusually steep yield curve undercuts those expectations. It instead reflects anxiety over the timing of a Fed rate increase and an uneasiness that it will keep rates too low for too long and cause a resurgence in inflation.

Concerns of rising interest rates have persisted despite the Fed’s pledge it will keep borrowing costs at record lows for an “extended period” until a recovery is sustainable.

These nagging worries have fueled demand for Treasury bills even though they are yielding close to nothing, while bidding for longer-dated Treasuries has been uneven at auctions.

“There are longer-term concerns about fiscal and monetary inflation,” said Jim DeMasi, chief fixed-income strategist with Stifel Nicolaus & Co. in Baltimore.

The gap between two-year and 10-year yields widened to 2.65 percentage points early Friday from 2.63 percentage points on Thursday -- more than double its 20-year average of 1.15 percentage points, according to J.P. Morgan Securities.


The U.S. central bank’s ultra-loose rate policy is meant to stimulate risk-taking in an effort to energize lending and investments. Cheap short-term loans should entice banks to lend and investors to buy riskier assets to make money.

This goal has achieved some success. The flood of cash has made its way into stocks, junk bonds and commodities. These investments are much riskier than long-dated Treasuries but their returns have been vastly superior.

Long-dated Treasuries are viewed as less attractive because investors worry current low yields will not keep up with inflation over time. As a result, they are not safe enough for risk-averse investors nor profitable enough for those chasing maximum yields.

“There’s still an aversion to move out the curve. People are expecting the short-end (yields) to move up,” said Aaron Kohli, an interest rate strategist at RBS Securities in Stamford, Connecticut.

Year-to-date, the Standard & Poor’s 500 index has risen 23 percent, gold 30 percent and junk bonds 50 percent.

Benchmark 10-year Treasury notes were yielding 3.37 percent on Friday, while two-year notes offered a 0.72 percent. Three-month Treasury bills lagged with a measly 0.02 percent yield.

After extracting long-term inflation expectations, which are running more than 2 percent, 10-year Treasuries are yielding just a little over 1 percent.


But banks remain reluctant to lend to small business, which hurts their chances for expanding operations and increasing employment. Instead these gate-keepers of cash -- which are still hurting from bad mortgage investments -- have been socking money into Treasuries and low-risk securities, according to Fed data.

On Wednesday, U.S. Treasury Secretary Timothy Geithner said tight credit for small business would hinder the economic recovery and called on banks to lend more to smaller firms.

“Without increased access to credit for American families and small businesses, growth will be weaker, companies will defer long-term investments and we will not be able to create a recovery that is self-sustaining and led by private demand,” Geithner told a small-business financing forum hosted by the Treasury Department.

U.S. commercial banks’ holdings of Treasury and agency securities totaled $1.377 trillion in October, up from $1.222 trillion a year earlier.

In contrast, the amount of commercial and industrial loans on their books declined to $1.378 trillion in October, down from $1.643 trillion a year ago.

Analysts and Fed officials have blamed this resistance “to borrow short and lend long” -- the tenet of lending -- as a key factor that has forestalled a quick economic rebound.

To be sure, some analysts said other factors -- preference to hold cash and cash equivalents at year-end and concerns over United States’ losing its coveted triple-A rating -- have kept the spread between short- and long-dated yields so wide.

The yield curve will not stay this steep when investors jump back on the risk-taking wagon and scour for profitable curve trades once the new year begins, they said.

“You have a lot of money managers who did pretty well trading in 2009. You are seeing some de-risking of portfolios,” said Bill Bemis, portfolio manager with Aviva Investors North America in Des Moines, Iowa.

Editing by Theodore d'Afflisio

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