Investors Should Fear a Steeper Bond Yield Curve
Many analysts point out that a flat or inverted yield curve may presage a recession, so last year’s major shrinkage between short- and long-term U.S. Treasury rates is a disturbing sign. The curve has recently steepened a bit, however, suggesting investors now fear that Federal Reserve policy could allow inflation to become embedded in the economy. That would also be a concern. Can both be threats to the markets? Yes, but not at the same time.
Some Fed officials suggested last year’s flatter yield curve was enough to deter them from supporting additional interest-rate increases. This concern was illogical and excessive. The Treasury curve can flatten and even invert without necessarily leading to recession. But then, the steepening of the yield curve over the past month is not necessarily a good sign, either.
Curves tend to steepen quite dramatically as the economy goes into recession and policy makers react by cutting short-term rates to lower financing costs and moderate the economic decline. Markets recognize that reducing rates is intended to promote an economic recovery and, in due course, rates will revert to more normal levels. Thus, long-term rates do not decline as much as short-term ones, causing the curve to steepen. This is commonly taken as a sign that policy makers are behaving appropriately.
The curve can also steepen for less benign reasons. If the Fed fails to increase rates even though market conditions justify a higher rate structure — as when inflation is accelerating and Fed policy is not responding adequately — the curve will steepen to reflect concern that faster inflation will punish bond investors by eroding returns. The lack of a Fed response keeps short-term rates pegged at low levels. But if investors conclude the central bank is paying inadequate attention to inflation, they will sell longer-maturity bonds, since those are most vulnerable to inflation. These bond sales pressure yields higher, thereby steepening the curve.
A good example of this market behavior occurred during the short period when G. William Miller, nicknamed “easy money Miller,” was Fed chairman in the late 1970s. A bio of Miller on the Fed’s website noted that “unlike some of his predecessors, Miller was less focused on combating inflation, but rather was intent on promoting economic growth even if it resulted in inflation.” Despite concerns over rapidly accelerating inflation, which quickened from 9 percent on a year-over-year basis in December 1978 to 11.1 percent in June 1979, Miller only minimally increased the federal funds rate, from a target of 10 percent target to 10.25 percent in the same period. The gap between two- and 10-year Treasury yields went from negative 83 basis points to negative 7 basis points in July 1979, reversing the prior trend toward a deeper inversion.
Miller was “promoted” to secretary of the Treasury in August 1979, quite obviously to get him away from monetary policy. But inflation was surging, and in October the newly appointed Fed chairman, Paul Volcker, started jacking up policy rates by leaps and bounds to begin the lengthy process of reining in inflation that had been allowed to go unchecked for too long and become embedded in the economy.
Given a choice of a flatter curve reflecting the Fed’s policy actions to normalize rates versus a steeper curve because the Fed responds slowly to the tightening of the labor market and growing inflation pressures, investors should prefer the former. By hiking short-term rates, the Fed stands a better chance of avoiding a punishing rise in the cost of capital to households and business that could threaten the expansion.
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