Why A Rising Yield Curve May Be Good News

Treasury Yield Curve

Treasury Yield Curve Source: The U.S. Federal Reserve hide caption

itoggle caption Source: The U.S. Federal Reserve

There are a few reasons to be cautiously optimistic about the nascent economic recovery.

GDP is rising modestly; the stock market is near a one-year high; and the dollar continues its rise on stronger corporate news and growing concerns about risky emerging markets from Europe to the Middle East.

One more positive harbinger of good news: the yield curve — a key predictor of the economy — hit a record high Tuesday, signaling investors are growing more optimistic about the health of the economy.

The definition of the yield curve sounds jargony. It's the relationship between yields and maturity dates for a portfolio of similar bonds at a given point in time that helps illustrate the direction of interest rates. In short, it's the spread between long- and short-term interest rates.

Since President Richard Nixon announced in 1971 that the U.S. dollar would no longer be based on the gold standard, initiating the era of floating exchange rates, economists have argued that the slope of the yield curve is a good predictor of future economic activity.

In situations when this gap increases, like right now, the economy is expected to improve quickly in the future.

This type of curve can often be seen at the beginning of an economic expansion (or after the end of a recession). Here, economic stagnation will have depressed short-term interest rates; rates often begin to rise once the demand for money is restarted by growing economic activity.

Historically, the 20-year Treasury bond yield has averaged approximately two percentage points above that of three-month Treasury bills.

This week, the difference between shorter-term 2-year notes and longer-term 10-year note yields is now at its highest level ever at 2.86 percent.

It finished Monday at 2.78 percent, which topped the previous record of 2.76 percent set in June. A year ago, the gauge was at 1.29 percent.

The last time the yield curve was even near current levels was in 1992 and 2003, when the economy was coming out of recession.

The rise in Treasury yields also underscores growing anxiety about rising U.S. debt levels, as government spending drives the deficit to a record $1.4 trillion, and the resulting specter of future inflation.

Investor appetite for longer-dated government bonds falls on expectations of inflation because inflation eats into a bond's fixed return over time. Shorter-dated maturities suffer less as their yields are anchored by the Federal Reserve policy of keeping short-term rates at historically low levels. Bond prices move inversely to their yields.

As investors are turning to riskier assets for higher returns, the U.S. government may need to pay up for a record amount of debt sales to fund a widening budget deficit while supporting the economy.

One big caveat: if the Fed continues to keep short-term rates at historic lows it could create new asset bubbles and lead to even more inflation. That, in turn, could warp economic growth. And higher longer-term yields would eventually lead to higher mortgage rates, which could in turn eventually slow or stop any recovery in the housing market.

For right now, the news is at least partially comforting. But, as any economist will say, beyond that no one knows for sure.

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