Post-FOMC Yields 2: Curve Flattening!
Strangely, the long end of the curve has not responded as well, or even as expected, to the Fed’s 5 basis point adjustments. Contrary to what has been going on in the short end, as well as the belly, of the curve, the long end has actually moved lower.
From the chart, you can see that while the 2s and 5s are quite clearly off their 10 June lows, the 10s and 30s are not. Furthermore, while the 2s are higher by about 5 basis points, and the 5s down by about 2 basis points since last week’s FOMC meeting, the 10s and 30s are both down by about 10 basis points over the same period.
Consequently, the yield curve has flattened, as can be observed in the chart below.
Looking at spreads between the short and long ends of the curve, we can see that the yield curve has flattened quite a bit over the past week. This has been the most pronounced in the 2-10s and 2-30s spread, which have contracted by 13 and 14 basis points respectively (at time of writing). What does this flattening tell us?
Firstly, that the bond market is not sanguine about the prospects of long term inflation in the United States. This is very clearly expressed in how yields of 10s and 30s have moved appreciably lower over the past week, and in the lower 2-10s and 2-30s spreads.
On the other hand, the yields of 2 year Notes moving higher over the same period point towards expectations for higher near term inflation. This could be in relation to Covid related disruptions that are still plaguing global supply chains in numerous markets like container shipping, copper, oil (article is old but still relevant given the still high price of oil), and microchips.
Therefore, we have higher prices in the near and maybe medium term from these disruptions, and thus higher 2 year and 5 year rates. But, lower prices when the disruptions get worked out in the longer term, and hence lower 10 year and 30 year rates.
It is important to note that even as the yields on 2s and 5s move higher in response to what they perceive the Fed to be doing, this isn’t in response to projections of higher economic growth. That is, higher expected prices from supply disruptions are not the “good kind” of inflation that the economy wants and needs so badly.
Moreover, looking at the chart of spreads above, we can see that the curve has been flattening since April of this year. Fed or no Fed, floor or no floor, the yield curve is pricing in an economic recovery that is nowhere near robust enough in terms of breadth or sustainability. It simply isn’t expecting the kind of widespread rise in growth across jobs, wages, and activity that is required to create long term inflation. This is illustrated by long end yields falling appreciably over the last week. If higher economic growth was expected, we would see rising yields across the entire curve, with some tenors rising faster than others, not the flattening that has been going on for the past (almost) 3 months.
Given all of this, especially how 2s and 5s are pricing in higher levels of “bad inflation” from supply issues while the long end is pricing in lower growth prospects, stagflation is becoming more of a threat with each passing day.
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