STAFF NEWS & ANALYSIS
Federal Reserve Puzzled by Yield Curve Steepening
By - June 01, 2009

The Federal Reserve is studying significant moves in the U.S. government bond market last week that could have big implications for the central bank's strategy to combat the country's recession. But the Fed is not really sure what is driving the sharp rise in long-dated bond yields, and especially a widening gap between short and long term yields. – Reuters

Dominant Social Theme: It is a conundrum, apparently. A puzzle to even the brightest monetary minds …

Free-Market Analysis: Oh, Mama! Once again top central bankers grapple with the deepest problems of high finance – and admit the struggle is a most difficult one. Are we supposed to empathize? It is all so complicated, apparently. More data is doubtless needed; more analyses should be conducted; more discussions are necessary. In the meantime, the collective head-scratching will continue. Here is how the Reuters article (excerpted above) presents the options:

Do rising U.S. Treasury yields and a steepening yield curve suggest an economic recovery is more certain, meaning less need for safe haven government bonds and a healthy demand for credit? If so, there might be less need for the Fed to expand the money supply by buying more U.S. Treasuries. Or does the steepening yield curve mean investors are worried about the deterioration in the U.S. fiscal outlook, or the potential for a collapse in the U.S. dollar as the Fed floods the world with newly minted currency as part of its quantitative easing program. This might be an argument to augment to step up asset purchases. Another possibility is that China, the largest foreign holder of U.S. Treasury debt, has decided to refocus its portfolio by leaning more heavily on shorter-term maturities.

So … apparently, the big fellows at the US Fed and Treasury can't figure out why bond prices are souring. Is it because people feel giddy about the economy and seek more exciting options? Or is it because buyers are frightened that bonds represent a broken economy, given that each American household is now some US$500,000 in debt? Here's what one wise old Fed head has decided, according to Reuters:

"I'm in wait-and-see mode," said one Fed official who spoke on the condition of anonymity. "We laid out the asset purchase plan and we're following it. That is going to have some affect on various interest rates, but together with a hundred other things. So I don't think we should be chasing a long-term interest rate," the official said. … Fed insiders said they have a problem blaming the steepening of the yield curve just on the extra supply of new Treasury debt. While there has been a sharp deterioration in the U.S. fiscal outlook, this has been evident for months and the dramatic steepening of the curve only occurred this week. Fed officials also believe that some better-than-expected economic data recently has encouraged investors to believe there is less need for the safe-haven of government bonds and more risk of inflation.

What are these people smoking (besides expensive cigars)? Do American central bankers (and their colleagues) really believe Treasuries are in less demand because people are growing more optimistic? And even if there are those who do believe this, where's the evidence? An onrushing commercial mortgage crisis plus a potential unraveling of literally hundreds of trillions in derivative bets – along with increasing hesitancy among the Chinese and Japanese to buy more American debt – would seem to mitigate against warm feelings any time soon.

We've written this on numerous occasions, but it certainly bears repeating (given the mainstream media hardly ever mentions it): Government cannot buy its way out of an economic collapse – any collapse, let alone this one. Once central banks have printed too much money in a given business cycle, and those funds have found their way into mal-investments (too many malls, houses, computers, cars, etc.), printing more money to support the mal-investments is simply going to sustain the downturn. So long as the ruined entities remain around, sucking funds from both the government and the private sector, the economy will NOT recover, or certainly not quickly. This is the same mechanism – the so-called Japanese Syndrome — that led to the "lost decade" in the Land of the Rising Sun.

Anyway, we do our own research (our per diem is less than a central banker's), and you know we haven't run into a whole bunch of happy people lately. We would discuss green shoots with them, but our acquaintances tend to look at us kind of funny when we start talking that way. Then they go back to drinking odorless substances out of shot glasses and mumbling how they've had to postpone their retirements and how their kids aren't going to college anytime soon, or not without a scholarship. So it's clear to us (even if it is not clear to the bankers) that people don't have a whole lot of confidence in America right now, nor its bonds, nor even the dollar.

The Fed – and the mainstream media that relays its dithering on a regular basis – can remain optimistic (potentially, ambiguously, endlessly, undecidedly optimistic) for months, or even years. That's what happened during the Depression when the recovery was always just around the corner. We see a different scenario: deleveraging, even deflation, before a final inflationary blow-off. When it happens, we think the inflation will be intense, more even than the 1970s because this is the same kind of business cycle, only on steroids.

After Thoughts

We keep waiting for Fed bankers – and European central bankers, too – to point to the price of gold and silver as a better indicator of what is going on than the mass of inconclusive data through which they apparently sift. Haven't these clever individuals noticed that gold is on its way to cracking US$1,000 again and that silver is over US$15? Are money metals not still a barometer of concern, given the way that paper money is headed? We think they are. In fact, we think that gold could double its price and silver could easily quadruple before this leg of the business cycle is concluded. Of course, even as that happens we expect central bankers will retain their cautionary posture – rump up, eyes down – continually inspecting green shoots. We'll keep watching, meanwhile, for the dawn of ever higher gold and silver prices – and their derivatives, too (mining stocks, etc.)

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