Interest Rate Roundup

Wednesday, March 07, 2007

Watching the 2-10 Spread

A lot of ink has been spilled about the yield curve in the past several months. Historically, an inverted yield curve has been a reliable indicator of looming recession or economic weakness. In the current cycle, here's how the yield spread between 2-year Treasury Notes and 10-year Treasury Notes has behaved:

* It first flirted with negative/inversion territory way back in November 2005.

* In early 2006, the 2-10 spread then went negative again and stayed so for a while. It hit a nadir of -16 basis points in late February before going positive again shortly thereafter.

* Finally, in June 2006, the 2-10 spread again went negative ... and basically stayed there all the way through present day. The deepest inversion? -19 basis points in November 2006.

Despite all this time in negative territory, the economy has continued to hang in there. GDP growth HAS slowed to the 2% - 3% range. But at no point have we slipped even close to recession territory.

My take: The yield curve economic signal has been distorted by the "money, money everywhere/carry trade" environment we've been in. Think about it: Investors have been borrowing cheap yen and cheap Swiss Francs to buy all kinds of global assets with higher yields (commercial real estate, junk bonds, corporate debt, etc.) Why wouldn't some of that money also make its way into long-term Treasuries? Sure, their yields are less juicy than the yields on other instruments. But they're still high enough vs. sub-1% Japanese rates to attract "carry trade" money. You also have central bank recycling of excess reserves holding down long-term yields.

What's noteworthy to me is that the inversion is now lessening. The 2-10 spread was recently just -4 basis points or so. If the carry trade/easy money trade is in fact unwinding, then it stands to reason the spread could disinvert further and even go back to positive territory, maybe in rapid fashion. The return of some longer-term inflation fear could also help disinvert the curve by hitting the long end (10s, 30s). After all, the year-over-year gain in the core CPI popped UP to 2.7% in January from 2.6% the previous few months, and energy prices are well off their lows of early 2007.
Will this thesis pan out? We'll just have to wait and see. But it's one thing I'm watching this fine Wednesday morning.


  • If only we looked at this posting a year ago, would have been a great forcast to the mess we are in right now.

    By Anonymous Anonymous, at November 7, 2008 at 11:30 AM  

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