Via InfoWire.dk
There’s certainly been enthusiasm for equity markets lately. Investors have been piling into US stocks, sending prices to record highs on the hopes that Trump will slash corporate taxes and stimulate jobs through fiscal spending, like building new airports. If these policies do come to pass, there’s little doubt amongst economists that wage inflation will be the result, given the US labor market’s relatively tight current condition. Wage inflation begets price inflation, so there’s a general expectation that interest rates will be higher. We’ve seen exactly this start to happen, as short-term interest rates have jumped since November 2016. But the long-end of the yield curve is saying something very different, and it doesn’t make much sense.
The difference in interest rates between 2-Year and 10-Year US government bonds is currently around 118 basis points (chart above). The 2-10 Year yield spread has expanded, as it normally should, over the past several weeks, from around 75 bps, and is wider by more than 57%. This is normal, because inflation expectations have increased. However, the yield spread between 10-Year and 30-Year bonds remains tight at around 61 bps, and has actually come down 26% over the same period of time. This is a divergence, and a notable one.
If inflation expectations are increasing for the next 10 years, what magical event occurs after that point to knock it back down? Higher inflation expectations should be reflected across the entire yield curve, especially as you go further out in maturity. Higher returns should be provided over longer time horizons. Instead, we’re seeing diminishing yields over longer periods, which means there’s a lack of economic optimism further out. Watch the yield spreads on both short and long-term yield curve segments for this kind of continued discrepancy. If it persists, expect longer term bonds to reprice more violently downward than they have so far.
