Let’s start by taking a look at the following chart, comparing the spread between the Ten Year and the Two Year treasury yields (using that as a proxy for the yield curve in general) and the price of gold.

(Click on image to enlarge)

As you can see, the spread between the two Treasury maturities has continued to flatten and is barely off its low.

Generally speaking, a flattening curve is a sign of a slowdown in overall economic growth. In the past, whenever the yield curve has become inverted (long term rates fall BELOW short term rates) a recession has followed soon afterwards.

I have noted in previous posts about this topic that given the current state of abysmally low interest rates, it is next to impossible for the curve to flatten further to the point of becoming inverted.

Also, during a time of a flattening yield curve, inflationary pressures are non-existent. If they were, bond yields, especially on the back end of the curve would rise causing a steepening of the overall curve.

It is evident that this is not happening.

Yet, today, we got the CPI number which showed some real signs of inflationary pressures building in the economy here in the US. Yet bond yields, instead of rising, actually moved lower during the hours immediately after the release of the data. So what gives?

I have been spending a fair amount of my spare time in analyzing this and attempting to ferret out some sort of meaning to all this. In the past, one of my favorite indicators for gauging the health of the US economy was this same yield curve. Now, suddenly, after all these years of faithful service, it seems to be abandoning me. This has disturbed me greatly.

The reason is has it because over the course of my trading career, I have come to place great stock in the ability of the bond market traders to cut through all the BS and noise taking place in the financial arena and honing in on what really is taking place in the actual economy.

Now I find myself questioning their ability to do just that anymore.

As noted in a previous post – we cannot have commodities as an asset class moving higher in anticipation of inflationary pressures building in the economy while we simultaneously have a yield curve that continues to flatten. The two are mutually exclusive of each other.

If the yield curve is steepening out, it is evidence that the most sophisticated traders on the planet see economic growth increasing and with that growth, a build in inflationary pressures. If the curve is flattening out, the opposite is seen by this same group of traders.

If growth is picking up and thus inflationary pressures, a rise in commodity prices accompanied by a steepening curve would make perfect sense. If growth was falling and deflationary pressures were on the ascent, a flattening yield curve along with falling commodity prices in general would also make sense.

What we currently have taking place is rising commodity prices and a flattening yield curve. This makes NO SENSE. Growth is either picking up in which case demand for commodities in general would be picking up or growth is not picking up. Which is it?

Here is where I currently am at in this quandary. I am beginning to think that what we are seeing taking place with the flattening yield curve is a DISTORTION of that once very reliable indicator that has been produced by the NEGATIVE INTEREST RATE environment conjured into being by the European Central Bank and the Bank of Japan.

Simply put, if you are an investor in those regions, what choice do you have in your search for SAFE YIELD? Answer – hardly any!

That is why we are now seeing 50 year bonds being offered in some parts of the Eurozone. One has to go that far out in order to obtain a yield of some measurable sort. The problems with that are evident – namely – a bond of that duration leaves one pitifully exposed if circumstances change and inflation does show up in those regions.

So what are some of those investors doing? Answer – they are buying US Treasuries instead; lots and lots of them.

While the yield on our Ten Year Treasury is pitiful at less than 1.8%, compared to what a buyer of the same maturity bonds in the Eurozone or in Japan can obtain, it looks downright stellar!

This yield differential is resulting in HUGE INFLOWS of foreign cash into our Treasury market which are working to push the price of those Treasuries higher which in turn is depressing their yield.

In other words, I fear that this negative interest rate environment overseas has produced such massive inflows into the US bond market, that it is destroying or perhaps already has destroyed, the predictive ability of the US yield curve.

This is yet another casualty of the constant, non-stop interference by the Western Central Banks ( I am including Japan in this category) in our markets. Their actions/policies have produced enormous dislocations of capital which I believe even they have not been able to predict would occur.

Here is where things might get even dicier. Let’s assume, for the sake of the discussion here, that the next US payrolls report is strong and that the previous month’s payrolls are upwardly revised. Let’s also assume that the continued increase in the CPI numbers, as we have been getting now for five months in a row, continue as well. Let’s also assume that we get some further improvements in US housing starts, retail sales, durable goods, etc.

In short, let’s assume that conditions here in the US get to the point where the Fed has no choice but to do the next rate hike.

Now let’s also assume that the sluggish growth continues in the Eurozone and in Japan. So what do we have? – a situation in which the Fed moves interest rates higher here in the US while the ECB and the BOJ keep interest rates negative over there. What do you think will happen to the investors in the Eurozone and in Japan when they see interest rates rising over here while going nowhere in their own region? That is obvious is it not? They are going to be emboldened to buy EVEN MORE US TREASURIES.

Now, what happens to bond rates over here when all that foreign buying of Treasuries actually increases over its already lofty levels? Answer – we might very well see yields on longer dated Treasuries actually decline after the Fed hikes short term rates here! Think about that for a minute.

The repercussions of this are enormous. You see, the Fed has direct control over the short term rates of the yield curve, but up until it engaged in QE, it never had direct control over the long end of the curve; that was left to the markets to decide the appropriate level.

It would be more than ironic if the very process of the Fed hiking short term rates to stave off inflationary pressures here in the US actually engendered a wave of additional foreign buying of US longer dated Treasuries that sent yields on those maturities in the opposite direction of what the Fed intended. The Fed hikes short term rates and long term rates here in the US actually move lower in response! Is it possible? After watching what has been happening with the yield curve this year I do not see why anyone could categorically dismiss it as out of the realm of possibility.

Maybe, and I am unsure about all of this, the reason we keep seeing the metals moving higher in the face of a flattening yield curve is that the Central Banks have so distorted the interest rate markets, globally and domestically, that they are irreparably broken as well. It would seem that our monetary elites, as they sit and scheme in their ivory towers about this policy and this response, have proved to be too clever for themselves.

They are the ones that created this insane environment in which obtaining normal and safe yields is next to impossible for investors. In their efforts to find yield, those same investors have now begun to move such large sums of capital that the Central Banks can no longer control the forces that they have unleashed. Those forces however are becoming increasingly concentrated in a handful of trades. As we all know from painful experience, whenever such crowded imbalances are created, the inevitable dislocation is exceedingly painful, chaotic and destructive.

Heaven help us all.