Yeah, so we’re starting to have some “trouble with curve,” so to speak.
Specifically, the spec short in the 10Y has been almost completely covered over the past three weeks as yields have come under pressure from a dovish Fed and the failure of the GOP bid to repeal and replace Obamacare.
Meanwhile, the record eurodollar short just keeps getting record-er-er which kinda makes it seem like maybe folks are betting on a policy mistak-ish flattening episode.
Well earlier today, 10Y yields abruptly fell to their lowest levels since before the Trump/Williams/Dudley combo reignited the reflation trade on Feb. 28., taking USDJPY and stocks along for the ride lower. To wit:
In light of the above, we thought the following from Bloomberg’s Cameron Crise was particularly relevant.
Via Bloomberg
One of the notable aspects of today’s Treasury-market price action — 10-year yields dipped as low as 2.33% — has been the flattening of the 2s/10s curve, which is now threatening its post-election lows.
- How concerned should the market be about the flattening of the curve? Bill Dudley seemed more worried about the level of yields than the shape of the curve last week, but is the yield curve doing something it shouldn’t?
- I built a simple model using three variables: the level of nominal Fed funds, the level of Fed funds versus the 10 year average real GDP growth rate, and the difference between the 10-year average in core PCE inflation and 2%. The latter two factors are designed to put the level of Fed funds into the context of longer-term growth and inflation trends.
- For such a simple model, the fit is surprisingly good, with an r-squared of 0.82. Obviously it missed some of the swings of the QE era, but even then it successfully identified the average of the period.
- What’s notable is that while the curve has been flatter than it “should” have been after the end of the QE taper, that difference is now close to as small as it has been. Indeed, the model suggests that the equilibrium level of the yield curve has flattened by 25 bps over the last six months. Of course, it also says that the curve is still about 25 bps too flat.
- Still, should the Fed deliver another 50 bps of tightening this year, taking the level of the Fed funds rate to the long-term average growth rate of the economy, the model suggests that the curve should flatten a further 25 bps.
- Of course, one could always wonder where the yields on Treasury bonds might be if the Fed didn’t own so many of them. With any luck, at some point this year we’ll start to find out.
- And who knows — that may be just the ticket to keep the curve steep enough to prevent possibly premature prognostications of recession.
