The gap between the 2 year and 10 year Treasuries has narrowed to its tightest level since late 2007, producing a very flat yield curve. In the old days (pre-2008), this would have indicated expectations of slowing growth. But in the “new normal” of massive central bank intervention, there is a different interpretation. Background: last week’s remarks by Fed Chair Yellen (her first public remarks since March) were significant as she said that it’s “appropriate for the Fed to gradually and cautiously increase our overnight interest rate over time”. Markets key on the word “increase” and “probably in coming months such a move would be appropriate”. This seemed to confirm that a rate hike this summer is very likely. The Fed is increasingly comfortable with signs of wage inflation, housing starts, oil price stability and overall economic conditions. The futures market indicates a 34% chance of a rate increase in June, with a 62% chance for July. So the 2 year Treasury yield is rising as that is closely tied to short term rates. Why isn’t the 10 year rising commensurately? Investors are “split” on the 10 year; some are selling as the 10 year yield has always been tied to a pick-up in inflation and overall economic conditions. But some investors are buying the 10 year (forcing the yield down) on the theory that the rate increase may lead to a “risk-off” trade resulting in increased buying of the 10 year T as a safe haven, hence the flattening yield curve. The markets will continue to be extremely watchful of the data. This Friday’s employment report will be very closely watched as the last major data point before the Fed’s June 14-15 meeting. ….stay tuned…
