Maybe the final climactic event is upon us. Maybe the final bubble to burst is the US Treasury market and maybe we are on the verge of a financial Krakatoa which will realign financial markets.
Whatever the case it feels like the calm before the storm and we are about to embark on another interesting expedition.
Ok, then. Best to try and figure out what's going on.
Very basically, the government is having a much easier time selling short duration debt than it is long duration debt. Both central banks and private investors are piling into shorter maturity bills and notes. The question is why. Potential explanations include waning interest from buyers who were seeking safety but who now feel comfortable buying things other than government debt, and investors nervous about repayment prospects. The main factor is related to both of these explanations -- investors are anticipating a recovery, and are anticipating that recovery will bring inflation.
Those expectations mean that interest in longer maturity bonds will decline until rates on those bonds rise; investors need to be compensated for the expected deterioration in the value of the dollar over the life of the instrument. The downside here is that the Fed has tried very hard to keep long-term interest rates low in order to increase investment and juice the economy, and the rise in long-term rates is pushing up the cost of things like 30-year mortgages. On the other hand, a little inflation and dollar depreciation would be healthy for the economy, provided that it didn't lead to a damaging spike in commodity prices.
But the real silver lining to the steepening yield curve is the effect on the banking industry. It certainly looks like we're committed to propping troubled banks up while they attempt to earn their way out of this mess, and a steep yield curve is good for bank earnings. So, you know, bright side!
Recommended additional reading: Brad Setser
Yes, those are the typical explanation of a steep yield curve, which is why normally it is a positive sign of future economic growth.
There is of course the tiny extremely negative alternative explanation. That is that investors are getting extremely nervous of the possibility of the government being unable to pay back the long term debt, though agreeing that the government will pay back the debt in the short run. To believe this, you have to believe that the projected increase in debt as a percentage of GDP (which measures in some sense the ability of the country to service the debt) is spooking investors.
I certainly hope that the latter explanation is not the correct one, as should we all. It's the doomsday scenario.
Here is a highly simplified but I think useful way of thinking about the yield curve that will explain the wide range in intuition.
The yield curve can be thought of as a sign of the relative supply of savings. When the yield curve is shallow or negative savings are becoming more plentiful. When the yield curve is steep savings are becoming more scarce.
A scarcity of savings is a good thing cyclically but a bad thing in the long run.
Recessions can be thought of as resulting from an excess in savings. Thus savings becoming more plentiful means that a recession may be approaching or that an ongoing recession is getting worse.
In the long run, however, all investment must come from savings and investment is of course an important source of per capita growth. So savings becoming more scarce can make us worry about the prospects for long term growth.
Where I think people go wrong is in treating interest rates as if they are exogenous rather than an equilibrium outcome. That is, some are suggesting that rising long rates will slow GDP because it will slow investment in housing.
However, long rates are rising BECAUSE someone, somewhere is spending the money rather than saving it. That is a good thing cyclically.
You might ask - If its such a good thing why was the Fed buying long bonds and trying to flatten the curve.
In short they had no other choice, but this event doesn't mess up our model. Savings were increasing. However, they were increasing because new money was being created. Normally when savings increases it is because consumption spending is decreasing. However, this time savings was increasing because there was more money in total.
Ideally, what the Fed would want to see is that it purchased 300 Billion in long bonds and rates not move at all. That would necessarily mean that the money was being sucked out the bond market and put somewhere else - most likely into investment or consumption.
I would look to the lack of carry, much like what we've seen in the long term muni market. Nobody ever really wanted a 30 year California bond, but the yields stayed low because there was money to be made in carry. It turned out that the seemingly safe carry trade in munis was actually a very risky highly leveraged option business, which like many other hedging strategies, blew up when the Black Swan flew in. It hasn't returned and is unlikely ever to return, now that the risks are more obvious. It's the same with the carry trade in long Treasuries -- the bond conundrum was simply a matter of carry and leverage. The end of the carry in long bonds wasn't as obvious with Treasuries as with munis because it was masked by the flight to safety demand, which drove long yields to very low levels. But the carry trade is really gone. Now that the flight to safety is tapering off too, the only buyers of long Treasuries left are real money investors. As with long munis, there simply aren't enough of them interested in owning long paper to keep the yields down, which is why they are headed up to a new and permanently higher plateau.