Short View: Yield curve

By Aline van Duyn, US markets editor
Published: December 22 2009 19:50 Last updated: December 22 2009 19:50

The bond markets have notched up another record for 2009. This time, the indicator in question measures the gap between short- and long-dated yields.
"Curve-steepening" so called...
The yield curve has steepened to its highest ever. That means the gap between 10-year US yields and the 2-year is wider than ever before. The gap is 286 basis points, eclipsing last week’s new peak of 276bp and the previous record set in August 2003 of 274bp.
With official US interest rates close to zero, it is not surprising that unusual dynamics are taking place in bond markets. Not only are near zero rates a historical anomaly, so is the fact that central banks are buying government bonds. There are plenty of reasons to expect strange things to happen to bond yields.
The question is what this steep yield curve signals. In the past, steepening has been a buy signal for equity investors. That was the case in 2003, as well as in July 1992, when it steepened to 268bp. Low short-term interest rates were expected to fuel economic growth and a return to inflationary pressures. These expectations were reflected in rising long-term yields.
There are sensible reasons why this interpretation could be hasty this time around.
First, the trigger for the steeper yield curve came last week, when the Fed signalled it would stay on hold for much of 2010. Short-term Treasury yields fell. This suggests growth will be weak and unemployment will stay high.
Second, an analysis by RBC Capital Markets shows that steep yield curves are not unusual in the middle of a period when interest rates are unchanged.
Third, markets often get it wrong.
The yield curve might be a bullish signal, or it might not. Investors are entering 2010 with a big question about the strength of growth in the US. There is no hope of a clear signal yet, from bond tea leaves or anywhere else.