Spread Between Short- & Long-Term Borrowing Increases

The difference between the rates for borrowing money for 2-years from the government versus borrowing it for 30-years has reached 4 percentage points, an unprecedented steepening in the so-called yield curve that is puzzling prognosticators predicting it means anything from a strengthening equity bull market to a catastrophic downgrade of USA’s credit rating.

The record spread between the 30-year long bond and the 2-year Treasury note is new territory for bond fund managers, economists and traders alike. But the resolution of this anomaly will affect everything from mortgage rates to the price of bread.

"With Treasury yields and commodity prices rising against the backdrop of a steepening yield curve, generally rising equity prices and narrow credit spreads, we believe the recent action in Treasury yields and commodity prices is a reflection of rising demand," said Michael Darda, chief economist and market strategist at MKM Partners. "In other words, it is due to a shift in the demand schedule and thus is a reflection of current/expected strength, not a cause of weakness."

In his bullish note to clients, Darda points out that the spread of 398 basis points is above the peak in October 1992 and July 2003. He also points out that an inversion of this spread foreshadowed a recession in 1989, 2000 and 2006, so a widening is good news.

"The Fed is artificially suppressing the short term rates such that the yield curve is unnaturally steep," said Simon Baker, CEO at Baker Avenue Management. "This makes me want to buy financials as this kind of spread is a great environment for them. Also, this adds fuel to the equity rally as there is a cost of being in safe, short-term debt of almost 4% per year."

But some fear that the government has to charge a higher borrowing rate 30-years out for good reason: mounting deficits and rising inflation increase the chance of a ratings downgrade. The chief risk officer at ratings firm Moody’s played down that concern in a comment to the Wall Street Journal today.

"There are a couple more ominous reasons for the decline in 30-year prices, one of which is the reduction in demand from China, and a small worry about the credit worthiness of U.S. debt going forward," said Jim Iurio, managing director of TJM Institutional Services. "Is the steepness in 2 to 30’s good news? On balance…yes, but not resoundingly so when you consider all aspects."

We’ll get some clarity on what exactly this phenomenon means on Friday, when the government reports it’s initial reading of fourth-quarter GDP. Weekly jobless claims are out on Thursday.

Some investors say an unprecedented financial move like this during unprecedented financial times like these calls for an unprecedented financial conclusion. Nicholas Colas, chief market strategist for BNY ConvergEx Group, posits that we could see inflation and deflation at the same time. For example, food prices could rise, but housing and wage prices could stagnate as unemployment remains high. That could cause the Fed to remain accommodative on the short end.

"What’s different this time is easy to see: the Fed sees a lot of slack in the economy, which threatens deflation," said Colas. "The overall CPI numbers are anchored by housing (42% of CPI) so food and energy inflation may be all we get. And that may not be enough to push the core higher. Which means the curve may steepen further this week, especially if GDP is good and the initial claims data is better on Thursday."

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Ref: http://www.cnbc.com/id/41234372

John Melloy is the Executive Producer of Fast Money. Before joining CNBC, he was an editor for Bloomberg News, overseeing the U.S. Stock Market coverage team.

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