Thursday, May 24, 2007

Insert Clever Title Here

The 10-year has sold off significantly in the last several days, the yield rising from 4.628 when it was sold to 4.88 today. A couple things are note worthy here.

  • 10-year rates have closed higher 10 of the last 11 trading sessions.
  • The curve has steepened from -5 on 5/9 To +2 today.

So what does this tell us?

Over the last several months, we've had mostly bear flatteners and bull steepeners. In other words, the slope of the curve was dominated by movement on the front end, not the back end. This indicated that the market was trading on near-term Fed expectations. In other words, since the 2-year is more sensitive to Fed activity than the 10-year, when the 2-year is leading
the market, its all about the Fed.

Lately, it hasn't been that way, its been the 10-year leading the way, and with a bearish tone. What is that telling you? That near-term, the Fed is on hold, so movement in the rates markets is going to be more about long-term economics and less about near-term monetary policy tweaks.

I also feel strongly that the curve should have some slope in the absence of Fed interference. Some commentators have theorized that the curve may be permanently flat for various reasons (lower inflation, foreign buying, pension buying, etc.). I disagree. I do think that confidence in the Fed's ability to control inflation in the long-term will result in a curve generally flatter than might have been 20 years ago. But this has been a long-term trend. And yet as recently as 2004 the 2-10 slope was over 200bps. If confidence in the Fed has been consistently increasing for, say, 10 years, why wasn't the curve also flat in 2004?

I think the "permanently flat" theory doesn't pass the basic logic test. The fact is that the slope of the curve (at least in the 0-10 year area) has been trading primarily on Fed expectations for years, and it continues today. The curve has tended to be steeper when the Fed starts a tightening phase, flattens as the tightening period matures, often inverts after the Fed is done and expectations for an easing grow. As the easy money period matures, the curve steepens again anticipating future hikes.

This is a well established pattern, and its exactly what we've seen in the most recent cycles. The curve inverted in 2000 as that tightening cycle was ending. Then rapidly steepened in 2001 as the Fed was cutting. The curve started to flatten as the Fed started hiking in 2004, then inverted again in 2006 as the tightening cycle ended.

So if you want to bet on a permanently flatter curve, you either have to reject this perfectly simple and logical pattern, or assume the Fed will permanently be on hold. I gotta tell ya, I don't like the odds of either.

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