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The Fed is behind the tightening curve





These two charts focus on the yield on 2- and 10-year Treasury yields from 1977 through today. The top chart shows the yields, while the bottom chart shows the difference in the yields, which is a measure of the steepness of the yield curve. If you compare the two charts, you will see that a steep yield curve generally corresponds to periods in which short-term rates are low, and that in turn is generally a sign of easy monetary policy. Steep curves typically flatten as short-term rates rise relative to, and more than, long-term rates. When the yield curve is inverted, short-term rates are higher than long-term rates; this is generally caused by very tight monetary policy, and this is what has preceded every post-war recession.

Today the yield curve is steeper than at any other time in history. This is the bond market's way of saying that short-term rates are exceedingly low, so low that they will have to rise by a LOT in coming years. The Fed has been keeping rates artificially low for quite some time now, and they will have to correct for this by raising rates by a lot in the future. The only thing we don't know is when they will begin raising rates.

This last chart shows the market's current expectations of what the Treasury curve will look like 1, 2, and 5 years from now. The bottom line is the current Treasury yield curve. I note that the market expects all Treasury yields to be significantly higher in 5 years than they are now. Note also that the market expects the curve to be slightly inverted 5 years from now, which further suggests that there is very little risk of recession for the next 5 years.

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