Recently we noted interest rate expectations on both sides of the Atlantic and how markets predict no rise in base rates from either the U.S. Federal Reserve or the Bank of England until 2014 at the very earliest. Indeed the central banks themselves appear to be implying this.
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New York Stock Exchange Traders
Perhaps this implication is meant to reassure markets that monetary policymakers will do everything they can to assist the fragile recovery? The optimism we spoke of last week is not shared by everyone, and central banks will be keen to ensure that nothing they do dents confidence in any way.
But leaving my opinion aside, can we point to market indicators that suggest the economy is beginning to be viewed in a more positive light? To borrow a historic phrase, yes we can. As always, it comes in the shape of the Treasury yieldcurve.
A low point for investors was last autumn, when the euro zone crisis looked terminal to many and the geopolitical situation over Iran was tense (more on that below). Added to that, investors did not have 3-4 months of positive U.S. jobs performance to raise their spirits, as they do now.
But since that September, the Treasury curve has risen absolutely and also steepened. The 2-year yield has increased by 14 basis points, the 5-year by over 20 bps and the 10-year by nearly 40 bps. The 2-5 year spread has widened nearly 10 bps and the 2-10 year spread is up 25 bps. These numbers suggest a change in mood to one that is more up than down.
Now, since when does a rising sovereign bond yield curve signify positive sentiment? When it’s at rock-bottom to start with. A steepening yield curve, as well as the rise in absolute yields, suggests that the market expects interest rates to be rising sooner than the 2015 date that the Fed has implied.
A rising curve today means investors expect yields generally to be rising and we wouldn’t be getting that unless the central bank thought the economy could stand it. Ergo, in today’s climate, the change in the Treasury curve is a “good thing”.
Return to Normal?
The change in the 30-year yield is also noteworthy. In September 2011 this had a "big-figure" 2 to it, this week it stands at 3.36 percent. This is a much more “normal” level for the long-bond yield, and suggests that we can start to think the economy is also returning to normal (although it will probably be the “new normal” of Mr. El-Erian).
What do curves say in the European Union? In the UK the picture is reversed, the curve is down and flattened compared with last autumn, but that is as likely to reflect the “safe haven” status of Gilts (government bonds) as it is to the expectation of when the Bank of England will start to hike rates.
In Germany the picture is more interesting still, the curve has had a pivotal shift, but then again the euro zone is further behind in the business cycle than the U.S.
So taking a second to look at the Treasury curve, always worthwhile at any time, reinforces our argument from last week that the economy has turned a corner.
A final comment about the geopolitical situation. It does appear that an attack on Iranian nuclear energy facilities is no longer imminent, and we are assuming that this stays the case for the time being. Of course if the situation deteriorated and turned “hot”, we should be in no doubt about the catastrophic impact this would have on the global economy.
It wouldn’t just be a case of crude oil trading at over $200 a barrel, it would also result in severe contraction in output as supplies of oil simply dried up in many countries. The Straits of Hormuz are only 21 miles wide at their narrowest and indeed at that point the navigable width is only 4 miles. It would not be necessary to patrol the seaway or even mine it to prevent access; just sinking a ship at the narrow point would be sufficient to block it for months. Let’s hope it doesn’t come to that.
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The author is Professor Moorad Choudhry, Treasurer, Corporate Banking Division, Royal Bank of Scotland.