November 03, 2016
The Fed has been hearing from regional Fed presidents that they need to tighten. However, one of the great problems in today’s environment is that if the Fed tightens, then the yield curve will most likely flatten. That is not good for depository institutions. They like steep curves. So what’s a Fed to do? They can “reverse” Operation Twist to pressure the yield curve steeper – you know, like the Japanese. Or, and why not, introduce into our vocabulary, once again, the word inflation. Long bonds hate inflation.
The Fed will typically try to impose its will on the curve through jawboning. So far so good. The curve has been pressing a bit steeper on all of this inflation talk. See below for a history of the 2yr/10yr spread represented by the white line, and the Fed Funds rate represented by the yellow line. You will see that historically when the Fed begins to raise rates the curve flattens. That, in today’s environment is unacceptable. They are sneaky!
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