Why Contrary To The Chairman's Lies, A Record Steep Yield Curve May Be The Most Bearish Indicator Available

Tyler Durden's picture

The most important characteristic of current capital markets, aside of course from now completely irrelevant stocks, which there is no point in even discussing any more as the Russell 2000 has become nothing more than a policy tool for Bernanke in pitching idiot Congressmen how "successful" his failed monetary policy has been when all it indicates is how good he is at manipulating stock prices, is the record steepness of the yield curve, as we have been pointing out month after month (oddly the topic never gets boring as it hits a new record wide with each passing month). And while to Ben the steepness is simply more good news to regale his questioners, who have no idea what the difference between a bond price and yield is, with, it is just as easily the most bearish indicator available. Nick Colas explains why "the bears also have more fodder from the steep yield curve than an
Alaskan salmon run: the long end of the curve could be blowing out over
inflation fears, persistent government debt issuance, or even a future
downgrade of U.S. sovereign debt." But don't worry- the Chaircreature will never acknowledge that there is a yang to every ying. Especially not when the ying has to be so well priced, that Bernanke's midichlorian count has to be off the charts to get his liquidity extraction timing perfectly and avoid either a hyperdeflationary or hyperinflationary collapse.

From BNY Convergex: Smoke from a Distant Fire, or what the 2s10s really indicates

Summary: The U.S. Treasury yield curve is setting records for its “steepness” – the difference between short duration yields and those that stretch out for 10 to 30 years. The current yield spread between 2-year and 10-year notes is now 290 basis points. We’re clearly in record-setting territory, but this is one of those data points that seems to fully support both full-on bullish and bearish viewpoints. History is on the side of optimism: the two previous periods of Matterhorn-like yield curves were in the early 1990s and 2000s and served as precursors to an improving U.S. economy and large gains for stocks. Yet the bears also have more fodder from the steep yield curve than an Alaskan salmon run: the long end of the curve could be blowing out over inflation fears, persistent government debt issuance, or even a future downgrade of U.S. sovereign debt. This argument will be settled by how much loan growth we see in the banking system, for that is the way steep yield curves traditionally catalyze economic growth.

People only see what they are prepared to see.” That quote comes from Ralph Waldo Emerson, the American 19th century writer and philosopher. While he meant it largely in a spiritual sense – his first vocation was in ministry – there is much truth to it when it comes to the world of investing. You only have to look as far as the tech and housing bubbles or the Financial Crisis to see that human judgment is strongly colored by what we want to see. What we are “Prepared to see.”

Nowhere is that sentiment more accurate than in the current state of the U.S. Treasury bond market. Let’s start with the facts of the case:

  • Most investors consider this to be one of the most efficiently priced markets in the world. There’s plenty of supply, first of all, with $9.5 trillion in public hands. And then there’s a healthy leverage component – even a retail Fidelity margin account will allow you to buy more than 4x your cash balance. An accommodating prime broker will give you far more leverage without much of a fuss. Even before you layer on a robust futures market, the monthly trading in U.S. government bonds totals some $500 billion every month.
  • The short end of the Treasury curve, less than 2 years or so maturity, is largely controlled by interest rate policy driven by the Federal Reserve. They set short-term rates with their decisions on the Federal Funds rate, the overnight interest rate used by banks to lend money to other financial institutions.
  • The yields at the long end of the curve, essentially 5 – 30 years, are determined primarily by expectations for future inflation. U.S. Treasuries have long been considered “risk free” so they aren’t supposed to discount any risk of default. More on that in a few minutes, though.

The steepness of the Treasury curve, defined here as the difference between 2 year and 10 year Treasury yields, is therefore an ongoing tug of war. On one side you have 11 people – the current size of the Federal Open Market Committee. On the other side is the open and highly liquid marketplace for government bonds. This struggle between closed-door policy and marketplace pricing is now at an important juncture. Consider the following (a 35 year chart of the 2-10 year spread follows immediately after the text):

  • The difference between 10s and 2s swings from occasionally negative to a more normal state of 50 to 150 basis points positive (10 year rates higher those for 2 years). “Inverted curves” – where short-term rates exceed the yield on long dated bonds – occurred in the early and late 1980s, and again in the early 2000s. Exceptionally “steep curves,” when the difference between short and long end exceeds 250 basis points, are just about as rare, occurring in the early 1990s and again in the early 2000s.
  • And of course, now. One key difference, however, between the today and the historical record is the current “stickiness” of a steep curve. Prior periods of 250 basis point differentials have been relatively fleeting affairs. The current spreads have been with us off and on – but mostly on – since 2009. That’s a result of the FOMC’s decision to leave short-term rates near zero for their “extended period” of time.
  • The yield curve is usually an excellent indicator of future stock market returns. Those who say, “You can’t time the market” must not have bond prices on their quote screen. Since the 1990s if you simply bought when the yield curve was 250 basis points steep and sold when it “inverted” you would have be in stocks when the market rallied and safely out of equities when they got choppy. In for 1992 – early 2000 (one down year, and positive returns from 4-31%), and for 2003 – early 2007 (all up years with returns from 3-26%). Out for 1989 – 1991, missing all the volatility of the first Gulf War, and from 2007 – 2009. You know what happened then.

The current spread, at 290 basis points, is extremely unusual and demands separate analysis. Three points on the state of play today:

  • There is solid economic reasoning for the “Yield Curve Indicator” as it relates to stock performance. This is not one of those market indicators, like hemlines or Super Bowl winning teams, which draws its strength from correlation rather than causation. Steep yield curves mean that the banking system has a powerful reason to lend more. Short-term money, in the form of what banks have to pay to retain deposits, is cheap. The return they get for lending that money over the longer term is much better, since the amount they can charge for loans like car notes or mortgages is higher. This encourages lending and loosens bankers’ cautious purse strings and spurs incremental demand. Economic growth ensues as easier credit spurs expansion. The increasing spread between the cost of money and the return from lending also helps bank profitability and allows them to rebuild capital bases damaged by recession.
  • The positive feedback loop created by a steep yield curve sounds pretty compelling, so what’s the bearish case? There are several  arguments, and they all essentially rest on the notion that “This time is different.”

First is the possibility that long-dated Treasuries are discounting inflation more than economic recovery. The Federal Reserve won a battle with inflation in the early 1980s, causing a long-term bull market in 10-30 year bonds. Now the Fed is actually trying to spark inflation - a very different dynamic. A strong dose of inflation, beyond the Fed’s ability to control it, would damage economic growth and give banks very little incentive to lend more, or produce little demand for capital from business managers. This would, of course, also drag down stock prices.

Second is the notion that the U.S. government is a less credit-worthy borrower than in past cycles.
The country’s budget deficit runs +$1 trillion a year and total debt-to-GDP is essentially 1:1. The past two years have seen the U.S. issue a dollar of new debt for every dollar it collects in taxes. Substantial cutbacks in Federal spending seem unlikely in the run-up to a Presidential election in 2012 and in the absence of a Greece/Ireland-style capital markets crisis. In other words, long dated U.S. government paper may well need to offer greater yields to compensate investors for what effectively a lower quality product. A loss of the highest ratings on U.S. sovereign debt would raise the cost of borrowing, dampening economic growth and stock prices.

If you focus on the short end of the yield curve, another reason why a steep yield curve may not be especially predictive pops out from the data. The Fed’s desire to push savers to become investors and lift stock prices is materially different from the central bank’s traditional approach to prior recessions. That may mean that a steep yield curve is more the result of a policy shift that requires lower short rates for longer than is customary.

If a steep yield curve is meant to spark loan growth, it has yet to create this outcome. According to the Fed’s own data (see here: http://www.federalreserve.gov/releases/h8/current/) growth in loans and leases on bank balance sheets are still stuck in neutral. Bank credit of all types was down 5.6% in December 2010 from the prior year. For the month of January 2011 bank credit is essentially unchanged to December. Some loans considered to be leading indicators are up, however. Commercial and industrial loans, for example, were up 7.6% in December although January has not seen any further advance.

“When you hear hoof beats, think horses, not unicorns.”
That old adage may well apply to the record steep yield curve. But the hoof beats at this point are distant. Like so many aspects of the current recovery, it may take more time than usual to see the results of a steep yield curve on lending and growth.


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c-rev with a twist's picture

Dude, I can't figure you out.  On one hand you openly degregate technical patterns on anything longer than '5 minutes', but then use charts exactly like that to make investment decisions.  I understand your anger at JPM and tape painting and I feel it as you do, but why do you then make decisions like blowing out your calls?  It seems to me that you should forego charts altogether and commit to the metal and buy on weakness.  If you think about it, your desire to sell only feeds the beast.

Turd Ferguson's picture

No, Blythe reads the charts and I fear she sees a chance to paint a H&S on the silver chart.

I disparage TA in the metals because the markets are now totally driven by fundos only. This drives my personal opinions. What Blythe sees and does are a completely different matter.

Re my silver calls...I blew out a couple because they expire in two weeks so I can't really take a $1 down move right now.

razorthin's picture

Looks about as headandshouldery as the SPX did in August 2010.  We know how that turned out WITHOUT the fundies.

william the bastard's picture

turd is a small, insiginificant gold pimp.

turd hovers over the dial so that he can hit the first post on zh


NOTW777's picture

i took trading profits yesterday off the jan 25 near term low. its been a good run

kudos to Nic L for nailing the bottom

SDRII's picture

Rhythm method

jus_lite_reading's picture

History doesn't always repeat exactly, but it often rhymes...

Point Being's picture


Midi-chlorians (also spelled "midi-clorians" or "midichlorians") are a microorganism in the fictional Star Wars galaxy, first mentioned in The Phantom Menace. They are microscopic life-forms that reside within the cells of all living things and communicate with the Force.[6] They are symbionts with all other living things and without them life could not exist. The Jedi have learned how to listen to and coordinate the midi-chlorians. While every living being thus has a connection to the Force, one must have a high enough concentration of midi-chlorians in one's cells in order to be a Jedi or a Sith.[7][8]

Creator George Lucas says that the midi-chlorians are based on the endosymbiotic theory.[9]

An ancient prophecy foretold the appearance of a chosen one imbued with a high concentration of midi-chlorians, strong with the Force, and destined to alter it forever. Anakin Skywalker was believed by many to be the chosen one. He had the highest concentration of midi-chlorians the Jedi Council had ever seen. He was possibly conceived by the midi-chlorians (parthenogenesis).[8] Lucas has said in interviews that Luke Skywalker had the same total midi-chlorian count that Anakin did at birth, though this does not necessarily make him the chosen one because Anakin did exactly what the prophecy foretold by coming back from the Dark Side and destroying Emperor Palpatine.

In Revenge of the Sith, Palpatine tells Anakin that a Sith Lord, Darth Plagueis, had the ability to use the Dark Side to influence midi-chlorians to create life and to prevent people from dying.


Symbiont, out.

jus_lite_reading's picture

Bravo. I remember this from long ago- when yields rise as a result of increased demand and economic growth, then you're on the right path but a slowdown of the amount of growth is possible. When yields rise as a result of inflationary pressures but decreased economic growth, then you're screwed. Or round about what they taught in kindergarten.

alien-IQ's picture

why do I love ZH? : "Chaircreature".

nuf said.

Canucklehead's picture

Is the yield curve too steep because the long end is too high or is the short end too low?

It makes a difference...

TonyV's picture

Long end is not high by historical standards.

ivana's picture

here comes a genius silver bullet idea!!!
why not making current long end look like future short end?


IrishSamurai's picture

Must ... close ... green ...

[Brian Sack finishes on Benron's face ...]


papaswamp's picture

Dude you just poked my mind's eye out.

IrishSamurai's picture

Just giving the play-by-play at 3:55 PM, every day in 2011 at:

33 Liberty

100 F Street, NE

Well, at 100 F Street it is pretty much a finish every two hours or so (depending on the internet speed, nap schedule, and ham sandwich delivery ...)

jus_lite_reading's picture

Oh shit! The basturd got him right in the eye and pushes the "UP 6.71%" on the computer. What a mess. Even his yamaka is covered.

apberusdisvet's picture

Assange is said to have recently stated that the BAC dump is a big snore; he can't find anything incriminating from the 2006 info because he doesn't know enough about bankster policy.

NOTW777's picture

gee, where are all those guys who were worshipping him

jus_lite_reading's picture

Bullshit. Show me where he said that.

jus_lite_reading's picture


jus_lite_reading's picture


alien-IQ's picture

that's eight in a row for the DOW (and 12 of the last 14)..

alright people...move along...nothing to see here....

jus_lite_reading's picture

There is a reason for this- Yahoo for the past few days has had the words "stock prices" as a top entry. Know why? The average dumbass thinks the stock prices are going up because the economy is really recovering. We know the drill.

NOTW777's picture

WFMI popping on earnings

AccreditedEYE's picture

Especially not when the ying has to be so well priced, that Bernanke's midichloriancount has to be off the charts to get his liquidity extraction timing perfectly and avoid either a hyperdeflationary or hyperinflationary collapse.

LMAO!!! Nice Darth Bernanke, everything is proceeding EXACTLY as you have foreseen...


6 String's picture

Everything is wrong and eery. The steep yield curve is just one more indication that something is seriously going to go nuts soon.....but what?

I think we'll know soon.

jus_lite_reading's picture

Those who have been in the markets longer than Ben has had a PhD know this is getting very worrisome. This means only one thing.

BurningFuld's picture

After the elections in Ireland things could get ugly fast.  Check the current article on Mish's blog:


If Lenihan was pushing for haircuts then haircuts are a 100% guarantee with a new government. You might want to be out of Bonds...NOW!

RobotTrader's picture

Bears destroyed again.

The PigMen won't stop until all the bears throw in the towel and start buying stocks.

Especially Tom O'Brien, Larry Pesavento, and David White over at TFNN.com who are still clinging hard to the bear case.

AccreditedEYE's picture

I'd hardly call the Index performance today "destroyed" for the bears. YAWN!! Call me when Nazz breaks out of 2800.

RockyRacoon's picture

Just wondering, how will you save yourself from the stampede?   What entrepreneurial tricks do you have up your Robot sleeves?

SashaBelov's picture

WTF does it mean:

wti/brent spread today hit all time high at -15.4/bbl!




buzzsaw99's picture

Cushing doesn't need the oil at the moment. usa demand has been down.

razorthin's picture

Don't plan on being fooled into shorting again.  But here is a trade trigger everyone should have on - a buy-stop on a major index inverse etf amply above the 200-DMA (as not to get a head-fake trigger by the MM criminals).  Don't bother with a short of a long index since the issue will be conveniently unavailable upon the trigger.

If, ahem, when this happens, you can be pretty confident that it's game over.  And, you will wake up smiling one day when the rest of the world is crying.

mynhair's picture

"a major index inverse etf"

Dope has an ETF now?

Monday1929's picture

Anyone know if Japan has seen similar yield curve profile at any point over past 20 years?

ella's picture

Uncle Ben exposed his genius again by claiming that the only problem with Congress' move to prioritize the debt payment would be a computer problem.  Does he not understand that once prioritization occurs for one class of US creditors it can happen to other classes at the will of Congress?  

Now why would anyone buy treasuries and risk being included in the class that is paid last or not paid at all?  Will this scheme also filter down to the states?  Which class is next?

Watch out China your treasuries could be next.  And then maybe the treasuries that Uncle Be holds.

barliman's picture

Interesting article with multiple charts that reinforce Tyler's post:


It also highlights why looking in the mirror at the last decade to predict the future is criminal incompetence:

"As bad as this may sound, and maybe we'll look like complete idiots before the current cycle is over, the prior decade in the clarity of hindsight was characterized as having witnessed two of the largest financial bubbles in US history - the equity related dotcom/NASDAQ bubble and the mortgage credit/housing price bubble. Both of these bubbles could not have existed without Fed complicity. Not a chance."

And it has an excellent chart following this explanation:

"In the chart below we're looking at the interest rate spread between 10 year UST yields and 2 year UST yields. Of course alongside is the S&P 500 to represent the movement of equities in the macro. Very quickly, when the red line that represents the yield spread between 10 and 2 year US Treasury rates is below zero, the Treasury yield curve is "inverted" (short term yields higher than longer term yields). This is exactly what we have seen historically prior to recessions. When the red line hits a peak (mid-1992, mid-2003 and now), the Treasury yield curve is what is called "steep". Ok, we've inserted the green colored areas to represent those periods in which the Treasury yield curve travels from the point of maximum "steepness" to inversion. These are the exact periods during which equities have put on their best price performance. They represent periods of official US economic expansion. The puzzle pieces all fit together quite nicely."

This time IS different. This TIME the correction will over compensate for a decade's worth of distortion.


snowball777's picture

Fractional reserve lending and securitization could blow these bubbles with or without the Fed.

TonyV's picture

People only see what they are prepared to see.”

And why does the author think that he is any different?