Thursday, 13 June 2013

The Steepening of the U.S. Treasury Yield Curve

Although it has been a rocky climb, the longer term U.S. treasury yields have been steadily rising since July last year. For example, the 10-year yield (DGS10) bottomed on 25 July 2012 with at a yield of 1.43% and closed at 2.20% two days ago. The 10-year treasury yield has hence increased 77 basis points (bp) in less than a year.

As all treasury yields with a maturity longer than two years have increased since last summer, the treasury yield curve has steepened quite sharply since. The steepening is not a result of higher expected price inflation however as the difference between the 10-year yield and the 10-Year Treasury Inflation-Indexed Security was "only" 2.07% as of 11 June, lower than 26 April this year when it was 2.38% and lower than the 2.10% as of 29 June last year (see here). The steepening of the yield curve was hence driven by an (expected) increase in real interest rates. If Jon Hilsenrath at the Wall Street Journal is correct that the Fed will ease up on bond buying later this year (the so-called "tapering", see here) and in view of longer term yields still being very low in a historical perspective, it would not be unreasonable to expect real yields to continue to climb higher going forward.

Also, if banks start employing their historically high cash reserves to other uses (than storing them as excess reserves with the Fed), either through increased lending, investing (part of) the excess reserves or increasing dividends, this could put significant additional pressure on expected price inflation pushing nominal yields substantially higher than they currently are. 

Such an increase in treasury yields could also put downward pressure on stock prices although the stock market appears to have, for quite some time, priced in a moderate increase in treasury yields (see report from 5 June titled The Spread Drops as Treasury Yields Rise: 10-year Average Earnings- and Dividend Yields, S&P 500 for more on this subject). 

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