Monday, February 15, 2010

A steep yield cuve - now what?

Yield curves are very steep given the very loose monetary policy. The market has actually seen bear steepeners because it is the back-end that has risen especially in 2009. The reason has been a combination of higher expected inflation and move to positive real rates. Note that real rates on the front-end of the curve have been negative since we have not had the strong deflation that was expected. On the back-end of the curve, there real rates have been positive with low but positive inflation. The real rate have moved positive under the expectation that funding costs will be positive.

What could be next is the bear flattener which usually happens two quarters before actual Fed tightening activity. Longer-term money market rates will start to move higher while long rates are anchored. This will cause the curve to flatten. Under this scenario, the expectation for the timing of a Fed policy change is the main driver for curve changes. This is fairly normal but the amount of uncertainty concerning the "when" is greater than usual. Most put the change in late 2010. The Fed itself is saying the same thing. This means that the curve may actually get steeper if funding problems increase.

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