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Searching for Meaning in the Yield Curve

In normal economic conditions (pre-2008 crash, before massive central bank stimulus became the norm), a flattening yield curve usually meant a recession was anticipated by the market. It indicated that long bond buyers were betting on slowing growth and a decrease in inflation. Now we are in uncharted territory without precedent where the aforementioned stimulus is not having the usual stimulative effect on prices and wages. Commodity prices remain low with the specter of China’s slowdown and worldwide demand slackening. With the Fed in data driven mode, last Friday’s wage index report was highly scrutinized. The report indicated a 0.2% increase for Q2 after 0.6% was reported for Q1, well below the Fed target of 2.0% annual inflation. This caused the 10 year treasury to rally, dropping to about 2.16%. Then came this week’s comments from Atlanta Fed President Lockhart that the Fed is close to raising short term interest rates in September and that there is a high bar to not acting. Those comments now cast a new light on data; it seems that only substantially negative news will deter the Fed from raising in September. Two schools of thought on the yield curve: (1) Short term rates (6 month to 2 year treasuries) are rising in anticipation of the Fed raising its short term rate, while long term rates (10 year and 30 year Treasury Bonds) are staying low as they are reflective of inflation expectations; or a more esoteric view is (2) Short term rates are rising in anticipation of the Fed raising rates, but it is raising too early and derailing the recovery, thereby dampening the long term picture….stay tuned… David R. Pascale, Jr.