Yield Curve

And so, Portugal flatlines, and in fact is inverted in the outer years. The bond market is waving goodbye to Portuguese paper which is now effectively trading on the Pink Sheets.

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.

Rich Bernstein who while at BofA used to be one of the few (mostly) objective voices, today got into a heated discussion with Rick Santelli over yield curves and what they portend. In a nutshell, Bernstein's argument was that a steep yield curve is good for the economy, and the only thing that investors have to watch out for is an inversion. Yet what Bernstein knows all too well, is that in a time of -7% Taylor implied rates, QE 1, Lite, 2, 3, 4, 5, LSAPs, no rate hikes for the next 3 years, and all other possible gizmos thrown out to keep the front end at zero (as they can not be negative for now), to claim that the yield curve in a time of central planning, is indicative of anything is beyond childish. A flat curve, let alone an inverted curve is impossible as this point: all the Fed has to do is announce it will be explaining its Bill purchases and watch the sub 1 Year yields plunge to zero. Yet the long-end of the curve in a time of Fed intervention is entirely a function of the view on how well the Fed can handle its central planning role: after all, the last thing the Fed wants is a 30 year mortgage that is 5%+ as that destroys net worth far faster than the S&P hitting the magic Laszlo number of 2,830 or whatever it was that Birinyi pulled out of his ruler. As such, Santelli's warning that a steep curve during POMO times is just as much as indication of stagflation as growth, is spot on.

The chart below shows the UST yield curve over the past 20 years: as is more than obvious, every single point left of the 10 Year is at record tights. The only question on everyone's lips is where do we go from here. And that is where the confusion really hits. The confusion is further intensified by the sudden collapse in the 2s10s and the 2s10s30s butterfly. The odd thing here is that a flattening move as violent as recently seen in these two curves, has historically preceded a rise in the Federal Funds rate as can be seen in the chart to the right, before the Fed began tightening in 1999 and in 2004. In other words a flattening has traditionally been a leading indicator to an economic improvement (as liquidity extraction tends to go side by side with a pick up in inflation and thus economic growth). Alas, this time around, a tight monetary policy is the last thing on the Fed's mind, and the economy is only starting to demonstrate it is rolling over into a second and more violent recessionary round. In essence, the Fed's interventionist intention of purchasing the entire curve (including the long-end), as recently announced by the FRBNY, has completely dislocated all leading signaling by the curve itself. As a result, speculation is now rampant as to what may or may not happen. A case in point are the divergent opinions of Bank of America and Morgan Stanley. While the former Merrill Lynch is advocating an outright 10s30s flattener, Morgan Stanley is sticking to its guns and continues to push for a steeper curve: this in spite of the collapse in the 2s10s from a records steepeness of almost 290 bps in May, to under 220 bps as of Friday's close: the over 25% collapse is enough to blow up most of the funds who had positioned themselves for further steepness. At least Morgan Stanley is consistent. Yet both banks urge clients to hedge their trades and provide creative ways to do so, as both realize the likelihood of being wrong, now that the Fed is openly the biggest market participant, is probably higher than the inverse.

Forward treasury rates, which are very close Fed Fund rate expectations, can be extracted from the treasury curve. If the treasury market is smart money, it's worth listening.

The slope of the US Treasury curve is at or near record steep levels across most of the combinations. What determines where the curve slope will be going forward? This analysis attempts to answer that question by looking at yield per unit of duration risk. - Kletus Klump

While hardcore readers will be quite familiar with the observations presented in the attached paper "Yield Curve and the Economic Cycles", by reader Kiril Yoradnov, novice bond enthusiasts should note the presented correlation between the shape of the yield curve and the phase of a particular economic cycle it resides in. Of note is that while the 2s10s was recently at all time record highs in the 290 bps range, the curve has since collapsed and was trading at 239 bps earlier even as the 2 Year is once again near all time record tights, an observation which in itself makesabsolutely no sense considering the stock market action, and is merely another validation of a market ill with Schrodinger's syndrome, where we now have inflation and deflation rampant concurrently, and, frankly, idiotically. Perhaps it is time to move on from colored swanreference when discussing the market, to those of felines caught in parallel states of existence until the vigilantes wake up and finally collapse Bernanke's middle-class theft function. Regardless, the question is whether the collapse of the 10 Year will continue, further flattening the curve, and setting of alarms everywhere (while illogical and manipulated stocks will no doubt be hitting 36,000 at about the same time just to prove to the world that Fed Chairmen see record stock levels and record economic output as precisely synonymous).

Rosenberg argues the nominal yield curve would be inverted right now if it were not for the fact that short term rates are essentially at zero.

Gone are the days when "green sh#%ts" was bleated daily on CNBC amongst a chorus of permabull snorts. Even the experts now recognize the recovery as a BLS swindle, and it is important to reintroduce the possibility of not only a low growth future, but one of outright and persistent contraction.

Here's one for the history books - this is what a semi-inverted yield curve looks like. The reason for the shaded area, and why the curve isn't inverted off the bat: the IMF has pledged your money, dear Americans, to make sure Greece can at least roll its immediately maturing debt. Americans, via the IMF and Ben Bernanke's Frankensteinian printing press are now guaranteeing the differential between 10% and 5% on Greek <1 year debt. And why? Is it going to prevent a Greek default in the end? Of course not, but at least US taxpayers can enjoy some of the the great moral gratification that being a part of the Komintern provides.

"I cringe when I hear men like Kansas City Fed President Tom Hoenig muse that the Fed will ultimately need to get the Fed funds rate back up to a 3.5-4.5% zone. I deeply respect Mr. Hoenig, both as an economist and as a man, but I just don't see why the Taylor Rule of the Forward Minsky Journey should apply to the Reverse Minsky Journey. Simply put, the 2% real Fed funds rate constant in the Taylor Rule should, in my view, be considered toast. In a world of deleveraging and hoarding cash it makes absolutely no sense to reward holders of cash with an after-tax real rate of return." - Paul McCulley, Pimco.

Harley Bassman, who used to run ML's RateLabs is back on the scene, now as part of ML prop (hmmmm) and we are happy to present his two most recent "Convexity Maven" research pieces. Not for the faint of heart - serious curve expertise required. And for those brave enough, an idea for one of the cheapest catastrophe insurance trades: "What to do ? The only reasonable “bear” trade is some sort of mid-dated payer spread. Buying 2yr to 5yr expiries will reduce the time decay issue so you will have more time to wait. More importantly, by selling the OTM payer you reverse the large cost of “dynamic” risk. This will be a huge carry reducer since you would now be paying for the Curve and Volatility risk vectors but selling the Skew risk vector. Since Skew accounts for almost 20% of the cost of a 3yr-10yr 200bps payer spread, this is significant."

The doctor recommended daily Fed reading/hilarity generating allowance presented for your late day pleasure.