Tuesday, February 8, 2011

Treasury Yield Curve

The Fed has officially lost control of the yield curve.  First it was the ten year and beyond but now the shorter end of the curve is being assaulted.  Just imagine if the Fed said they would be pumping $125 billion into equities each month for six months.  Would you ever expect equities to sell off?  That is exactly what the bond market has been doing.

The implications of higher yields cannot be understated nor should they be ignored. Bernanke is going to need to do something soon and try and stop the exodus.  Today's three year auction was not a positive sign with a very low indirect bid leaving primary dealers to buy over 60% of the auction.  The Fed cannot come out and say QE failed. They either have to cause a sell off in equities (and hope people rush to the "safety" of treasuries) or have to say the economy is improving so much, QE2 can be stopped.  The past few days we have heard from three Fed members (two of which are voting members) that they won't support QE3 but will the bond market wait until June when QE2 ends? Time is becoming of the essence.

Below are two charts of treasury yields from June 1, 2010 through February 8, 2011.

The first chart is of various maturities over time.  Yields actually dropped from the August Jackson Hole rumor of QE until the Nov. 2 official announcement.  Then rates, primarily the long end really began to move up. Most recently the one and two year maturities have begun to move rather significantly.

The second chart is the yield curve over time.  It is now approaching a record in terms of steepness.  In a normal credit cycle this would be advantageous for the banking sector but no credit is being formed.  Instead the rise for example in ten year treasury yields is having a very negative impact on housing prices, while the five year will put added pressure on commercial real estate that needs to be rolled in 2011.


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