The Mouse-Trap

Curve shapes most of the time give us some indications about the state of play of the business cycle. Curve inversion for example (long rates LT short rates) frequently signal recessions ahead while positive shaped curves (long rates GT short rates) signal normal & good times ahead. Looking at the US right now, the positive difference between 10y and 2y rates stands at an all time high of some 300 bp (0,80% versus 3,75%). It implies that the business cycle should be gathering steam and that inflation expectations are creeping up (inflation & liquidity risk premium increases as you move along the yield curve further in time) :

Evolution 2y, 10y UST and difference between both 1980-2001

It also has some implications on the term structure of the current US yield curve, the so-called forwards : they point to a very strong upward shift of short & midterm yields (1y to 7y) on a 5 year horizon; within 5 to 10 years from now, the curve inverts once again. This picture and outlook might induce to lure investors into the longer end of the curve (10y - 30y ). Some additional comments are however essential in explaining the current steepness of the curve and hence its implications :

1) At the front end, no further explanation is required : Bernanke considers 0%-0,25% as essential and sees no immediate danger for inflation. To maintain this all-time low short end rate, the justification is that inflationary pressures are quite contained. And "although the recovery is gathering steam, the gains in the labour market are far from sufficient to reduce the unemployment rate towards a level the FED considers to be acceptable"

2) At the long end, it's however a different game. Since the announcement of QE2, long rates have increased dramatically against the intentions of the FED. 10y rates have jumped from 2,60% to 3,75% while the long bond (30y) increased from 3,98% to 4,75%, causing already quite some collateral damage in terms of returns. And this is elementary and crucial : though the FED is not very active in purchasing bonds on this part of the curve, the upward shift is quite significant.

The danger is mis-interpretation of the facts : long term yields are creeping up but not necessarily because the business cycle has improved towards euphoria. It could very easily imply that there are not a lot of buyers present at these levels because they do not trust the nature of the game any more. This is what academic circles label "being in front of the curve" or "being behind the curve" : A central bank in control is "in front" when controlling the long end of the curve as well. "Being behind" basically means coming "too late". The fear is there that the FED will once again come too late, only interfering at gentle pace with small rate increases, not disturbing Wall Street too much. In the meantime, the long end will live a life on its own and up go long term rates as well. And with the FED at some point bound to disappear from the US Treasury market - end of QE number X - it is certainly bound to cause some shocks as well, the normal play of supply and demand. But then again, this is whatBernanke really wants, causing inflation expectations, and desperately trying to mask this agenda of inflating your way out of debt.

So if I were a mouse, living as a tramp in a daily 0,25% cheese environment, I would be very careful when a 3,75% cheese comes along : think twice and resist temptation. The best way in 60 seconds to describe what is going on, is to have a look at the Swedish Chef : always trying very hard and with the best of intentions but in the end, always a victim of his own brave efforts :

http://www.youtube.com/embed/nh8qryMFZb4

http://www.youtube.com/embed/j1KSaUEu_T4