US Treasury Yield Curve Steepens To 3-Year High

The Federal Reserve is widely expected to reaffirm its ultra-dovish monetary policy in today’s FOMC meeting and the futures market continues to price the odds of a rate hike at 0% deep into 2021. But real-world conditions in government bond trading are hinting, if only on the margins, that a post zero-forever world may not be forever after all.

Exhibit A is the gradual but persistent steepening in the Treasury yield curve over the past year-plus. The current 10-year/2-year spread, at +81 basis points (Dec. 15), is still unusually low by historical standards. But the spread has also been trending higher, in fits and starts, for a year-and-a-half and is now at a three-year high.

The US economy still faces a harsh winter as COVID-19’s spread continues to take an ever greater toll in lives and livelihood. But the 10-year/2-year spread has been quietly, persistently pricing in something other than a worst-case scenario. The shift has been slight, but after 1-1/2 years, the change is becoming conspicuous.

A similar recovery has been unfolding in the 10-year/3-month too, which is currently at +84 basis points.

A steepening yield curve is traditionally viewed as a market forecast for higher inflation and/or strong economic activity. By some accounts, both conditions apply.

“We don’t really see any need for the Fed to extend the average maturity of its portfolio purchases given the fact that financial conditions are extraordinarily easy,” says Subadra Rajappa, head of US rates strategy at Societe Generale. “Yes, the curve has steepened, but inflation expectations have also risen meaningfully. The employment picture continues to improve.”

Now that coronavirus vaccines are starting to roll out, it’s getting easier to envision a healing process in 2021 for the economy. The repair and recovery process is showing up in GDP nowcasts for the fourth quarter and in Q1 estimates for 2021. The Atlanta Fed’s GDPNow model, for example, is especially upbeat for this year’s Q4 data: the current estimate points to a strong 11.2% annualized increase (as of Dec. 9).

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