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Yield curve slope hits another new high

The spread between 2- and 30-yr Treasuries reached another new, all-time high today of 401 bps. As this chart suggests, it's not unusual for the yield curve to steepen coming out of a recession. This is typically driven by Fed easing, as the Fed attempts to provide more money to help the economy recover, and to compensate for the higher demand for money that usually follows in the wake of recessions. One side effect of a steeper yield curve is that this becomes fertile ground for bank earnings. Today, banks can borrow from the Fed at 0.25% and, if they choose, buy 30-yr Treasuries, thus helping to fund the federal deficit while also earning 3.75% net interest on the trade. If the mark-to-market risk of 30-yr Treasuries (which currently have a duration of 17.4, and thus stand to lose about 17.4% of their value if yields rise 100 bps) is too much, then banks can buy 10-yr Treasuries (which the Fed is supposedly going to be backstopping for the next 5 months, and which have only half as much price risk as 30-yr Treasuries) and pick up 3.25%.

In effect, what this says is that the Fed is greasing the skids for a lot of folks and a lot of banks and businesses. Corporate profits are already close to record highs, so it is not too hard to understand why the equity market is up 25% since the end of August.

The next shoe to drop will be a pickup in inflation. Recall that the CPI rose from a low of 1% in mid-2002, as the 2-30 slope passed 300 bps on its way to 360 bps in mid-2003, to reach a high of 4.7% in Sep. '05.

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