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Crescenzi: The Flat Treasury Yield Curve

The flattening of the yield curvehas been the worst kind, because it has been a “bull flattening,” which is a flattening that occurs amid a decline in market interest rates on both ends of the yield curve. In contrast, a “bear flattening” occurs amid an increase in market interest rates.

The curve has flattened because investors have become less optimisticabout the outlook for both the U.S. and global economy, enough so to alter expectations about the outlook on both inflation and monetary policy. Investors are increasingly of the belief that the inflation rate could continue to move lower and that the Fed will keep interest rates low for a prolonged period.

A major thesis in the first half of the year was that the U.S. economy would slow as a result of waning influence from fiscal stimulus and inventory investment.

Recent data have supported the second-half slowdown thesis, and this has affected the financial markets.

The broader theme that has been illuminated yet again is the idea that the deleveraging process, both for the public and private sectors of the economy, remains and will remain a potent force shaping the behavior of economies worldwide. Investors recognize that nations have reached the Keynesian Endpoint, where the last balance sheet has been tapped, forcing fiscal austerity upon all levels of government worldwide and affecting economic activity.

Further flattening of the yield curve is possible if economies continue to slow. Market interest rates are dictated by two forces in particular: the fed funds rate and the inflation rate. Of the two, only the inflation rate can move lower, and it is likely it will because inflation lags the business cycle by about two years, which means there remains perhaps another year of a declining inflation rate.

The flatter curve will narrow the net interest margins at banks by reducing the spread between bank funding costs and the rates at which they lend. Net interest margins recently increased, in part because of wider margins for credit cards, so there is a little wiggle room here before it becomes an important factor for the banks.

Consumers will be helped by the decline in market interest rates, but not materially.

Most consumers have loans tied to either the federal funds rate or LIBOR, neither of which is declining. Prospective home buyers will be helped but this is a small crowd. Moreover, the two main pillars of the housing market are consumer confidence and income growth, both of which have not strengthened materially enough to give the housing market any meaningful support. Businesses will be helped by the decline in long-term interest rates, as they will be able to borrow at lower cost, assuming spreads between corporate bonds and Treasuries does not widen, which they could because spreads typically widen in times of economic stress.

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Tony Crescenzi is Senior VP, Strategist, Portfolio Manager Pimco. Crescenzi makes regular appearances on financial television stations such as CNBC and Bloomberg, and is frequently quoted across the news media. He is also the author of "Investing from the Top Down," "The Strategic Bond Investor," and co-author of the 1200-page book "The Money Market."

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