Cleveland Fed Dishes On Yield Curve Signal

Check out the latest from the Cleveland Fed president,  Loretta Mester:

Mester advised that there is “no evidence” for thinking that a flatter curve signals a weaker economy at this time, Reuters reported. She added that “structural factors,” such as bond-buying by central banks, are compressing the curve.

Mester’s comments coincided with a further narrowing of the yield spread based on the 10-year and 2-year Treasury rates. The yield difference between the two maturities fell to 52 basis points yesterday (Mar. 27 26), close to the lowest level since the recession ended in mid-2009. In January, the 10-year/2-year spread dipped to 50 basis points, a post-recession low.  – Capital Spectator

We have been beating this drum for years.

The following is from our Reflexivity And Why The Fed Must Sell The Long End post last June.

Information Positive Feedback Loop
Many in the market,  we fear, are being hoodwinked by the flattening yield curve, however.  It’s purely the result of technicals and not economic fundamentals.

Nevertheless,  some still look to the badly distorted bond market as a signal of the health of the economy and act accordingly.   Such as delaying capital spending;  becoming more risk averse;  and cutting back on consumption, for example.

A flatter yeld curve also makes bank lending less profitable.

This could thus lead to what George Soros calls “reflexivity“,  a feedback loop where the negative, but false, signal from the bond market actually causes an economic slowdown or leads to a recession.   So much for efficient markets.

Recall the famous line of one prominent market strategist during the dark days of the great recession,

“ We’re in a depression. That is what the bond market is telling us.”

Or the ubiquitous,  “what is the bond market telling us?”    Come on, man!  – GMM

Time For The Reverse Twist

We have also recognized the flow of new issuance and the drying up of demand by the Fed and foreign central banks poses a new risk for the yield curve.  It is one reason, we believe, bonds have not been a benefactor of the “flight-to-quality” trade in this nasty correction, which is very rare.

We were surprised that the Fed did not unwind Operation Twist, where it swapped short-term bonds for long-term bonds, when it decided to end quantitative easing (QE).  The majority of the stock of long-term Treasury notes and bonds remains in the hands of the Fed and foreign central banks, which distorts the true market signal of risk-free yields.

Given that market and the global economy are now so prone and susceptible to perverse feedback loops, where a misread of the yield curve could feed into the real economy, maybe it is time the Fed finally unwinds Operation Twist.   It will surely steepen the yield curve and give us a clearer signal of “what is the bond market telling us?”

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