Is The Bulk Of Inflation Now Priced-In (Even More Than Meets The Eye)?
The Treasury Curve is much steeper ‘relatively speaking’ than even its high absolute levels imply – is this what Gold is reflecting?
Point 1 - The incentive/cushion for putting on steepener trades is at its lowest in 8 years (the last business cycle). This duration-neutral (pure curve play) level is considerably lower now than it was the last time the rate differential was as steep (Point 5). Another way of judging this is to consider the 2s10s steepener a crowded trade as all the carry has been crushed out of it.
Point 2 – The 2s10s curve has steepened dramatically in the last 6-9 months but if we look at Point 1 on the chart, the duration-equivalence has not changed much…
Point 3 – The same range of steepening we saw in Point 2 was also seen in Point 3’s period and look at the massive compression in the carry cushion on the steepener as rates dropped in the short-end dramatically. The convexity of the curve and the new lower rate environment we are in means we must judge the curve on a different (not absolute) basis.
Point 4 – As 10Y rates dropped with deflation worries in Dec 08 (and the curve flattened), steepeners felt pain and unwound we suspect. More critically to us is the fact that we have moved back up to the same steepness and close to same levels but due to convexity the carry cushion has been depressed considerably – implying to us at least that the curve is considerably more ‘rich’/steep than the absolute history would imply.
Point 5 – This period has similar levels of both steepness and absolute level in 10Y and we note that the carry cushion for the duration-neutral curve is considerably higher. This tells us that there was far less inflationary worries (curve steepness) priced into reality than we are currently seeing.
Point 6 – The trough in carry cushion (see other chart also) was above the carry cushion we have seen in the last six months. Does this imply a more crowded inflationary bet on the yield curve.
Does this apparent over-steepness and great-inflationary pricing relative to duration-neutrality imply recovery being priced into bonds despite the relatively low rates? Or is this cost push or currency devaluation inflation (rather than demand pull) echoing the move in gold recently. Add to this the fact that USA protection costs have risen recently (which portends a higher risk of dollar devaluation) and we worry that the worst side of inflation is being priced more into the curve than perhaps many would believe.