The Bond Market Is Tightening, The Fed Is In A Box, And The Economy Will Pay.

The yield curve is steepening. It follows the historical script dictated by the business cycle. This time it means a tightening action by the markets.

Source: St. Louis Fed

This is an incredible chart. Its implications could be particularly important for investors and strategists. It shows three yield curves measured as the difference in yields of Treasury instruments between 10-2, 5-2, and 10-5 years.

A rising curve means the spread between short-term and long-term duration instruments is increasing and the yield curve is steepening. The decline in the graphs shows the opposite – spreads are narrowing, and the yield curve is flattening.

There is another interesting pattern. The yield curve starts steepening just ahead of a recession (shaded vertical area). In more general terms, it starts steepening ahead of a period of slower growth in business activity.

The explanation requires more details, especially if one wants to understand what is happening now and why the Fed has become irrelevant. It may show how its past policies have resulted in an abdication to monetary policy, leaving the tightening and easing of monetary policy to the markets.

Source: St, Louis Fed

Let me explain. First, we need to look at the historical patterns of interest rates (see above chart). Shaded areas show recessions. The first behavior is that short-term interest rates (blue line) change more rapidly than the long-term ones. Then, interest rates peak close to the beginning of a period of slower growth in the economy, just ahead of a recession. The decline in short-term interest rates can be justified in two ways. 

The business cycle was already slowing down before the peak in short-term interest rates. Business borrowing was declining as managers tried to reduce overstocked inventories. The decline in short-term interest rates was further reinforced by the easing action of the Fed as it recognized the dangers faced by the economy. The sharp increase in money supply M1 always accompanied the decline in short-term interest rates. 

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Harry Goldstein 3 weeks ago Member's comment

These days, everyone wants to borrow, no one wants to save.

George Dagnino 3 weeks ago Author's comment

Agree.

Simone Radcliffe 3 weeks ago Member's comment

Yes, the steepening of the yield curve is a sign of imminent recovery.

George Dagnino 3 weeks ago Author's comment

Yes, but watch the trend of bond yields.

Texan Hunter 3 weeks ago Member's comment

American is in a lot of trouble. And unfortunately will only get worse with the Dems in charge. Trump may not have been perfect, but at least he was making America Great Again. Sadly most Americans don't seem to want that and voted him out of office.

Kurt Benson 3 weeks ago Member's comment

Good charts. Sounds like the worst may be over.

George Dagnino 3 weeks ago Author's comment

...as long as yields do not rise "too much".....you can enjoy a complimentary subscription to THE PETER DAG PORTFOLIO STRATEGY AND MANAGEMENT by going to www.peterdag.com....it will give you more insights on my thinking. (no c.c. needed)

George Dagnino 3 weeks ago Author's comment

Yes! But we need to watch closely the rise in bond yields.

Kurt Benson 3 weeks ago Member's comment

Very good point George Dagnino.

George Dagnino 3 weeks ago Author's comment

Thank you!!!...You can enjoy a complimentary subscription to THE PETER DAG PORTFOLIO STRATEGY AND MANAGEMENT by going to www.peterdag.com....it will give you more insights on my thinking. (no c.c. needed)