The only way is up? The U.S. yield curve has steepened markedly since the Federal Reserve announced its decision to buy $600 billion of medium-term Treasurys, with the gap between two-year and 30-year yields at record levels around 3.86 percentage points.
That move points to the contradiction at the heart of quantitative easing: A policy aimed at lowering yields should ultimately deliver higher yields. The benefit of the Fed as a price-insensitive buyer risks being overwhelmed by investors anticipating a reflation of the economy. That could mean higher interest rates and capital losses for bondholders.
The overall steepness of today's Treasury curve is understandable: The Fed is promising to keep policy rates low for a long time, thus anchoring two-year yields. The price of the 30-year bond, meanwhile, has suffered. It is largely excluded from Fed bond buying, and its long maturity makes it the most sensitive Treasury to a perception the central bank is willing to tolerate higher-than-targeted inflation.
But that doesn't tell the whole story. There are probably three sections of the yield curve to look at when judging the impact of quantitative easing, or QE. An interesting move has come at the very short end of the curve, with one-year rates still anchored below 0.3% but with three-year rates rising to 0.81% from 0.5% since QE2 was announced. Credit Suisse suggests that if this rise persists, it could reflect market faith in QE, as it would suggest rate hikes are becoming more likely. Conversely, if this part of the yield curve were to flatten again, it might suggest the impact of the Fed is fading.
Then there's the five- to 10-year portion of the curve, where the Fed is concentrating its firepower, because these yields are key for consumer credit rates such as mortgages and car loans. Both five- and 10-year rates have risen versus two-year yields, but this heavily manipulated part of the curve might flatten again as Fed buying increases to soak up new supply.
Finally, there is the 10- to 30-year part of the curve, which is pricing a gamut of risks, among them inflation and potential fiscal risk. With fewer natural buyers of bonds at the long end, moves may be somewhat exaggerated. Ultimately, however, persistent signs of higher inflation expectations in 30-year Treasury prices could feed back down the curve.
The yield curve can send confusing messages, it can overshoot, and the signals can be early. But investors who ignored an inverted yield curve in 2006 and 2007 were caught when the economy imploded and interest rates were slashed. Those ignoring it again do so at their peril.
Write to Richard Barley at email@example.com