Saturday, May 30, 2009

The yield curve and the credibility of central banks

An increase in the yield for 10 year bonds put the yield curve in the US at one of its steepest since the mid-70s raising concerns about the evolution of long-term interest rates and the effect that they might have on the economic recovery. From Bloomberg, you can see that there are two ways to interpret the increase in the yield: Timothy Geithner thinks this is a good sign

Geithner also said that the rise in yields on Treasury securities this year “is a sign that things are improving” and that “there is a little less acute concern about the depth of the recession.”

Others see this as a sign of concern

Gross said in an interview today on Bloomberg Television that 
while a U.S. sovereign rating cut is “certainly nothing that’s going to happen overnight,” financial markets are “beginning to anticipate the possibility.”

Typically, a steep yield curve is a sign of a strong recovery, but there is nothing typical about current monetary policy. Here and here are two blog entries that discuss the recent steepness of the yield curve in the US.

One thing that I find interesting is that despite the uncertainty surrounding the current economic situation, the yield curve is almost identical in the Euro area (Germany), the UK and the US (see chart below). This means that not only the perception of a default risk for these three government is similar, which is probably a reasonable guess, but also that inflation expectations are almost identical for the ECB, the Bank of England and the Federal Reserve. 

While it is difficult to imagine circumstances where the inflation rates in these three areas deviates by a large amount, it is not that unlikely to build scenarios where inflation differentials are larger than the ones implied by those yield curves. Given the uncertainty and the difficulty predicting which ones of these scenarios will prevail, the yield curve seems to be anchored by the assumption that the three central banks will adopt very similar policies and will deliver an almost identical inflation rate. That's a strong sign of confidence on these three central banks.

Antonio Fatás