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The U.S. Treasury Yield curve is a sensitive indicator of economic trends (or at least, bond investors' expectations of economic trends).

The Treasury market is global and liquid. Like all other commodities, it responds to supply and demand. Bond yields move inversely to bond prices. When supply/demand pushes the price up, the yield drops and vice versa.

In stable times, the yield curve is positive (long-term yields higher than short-term yields) during economic booms and relatively flat during economic doldrums. The yield curve goes negative (short-term yields are higher than long-term yields) before recessions.

In unstable times, investors often buy Treasuries as a safe place to store their money ("flight-to-safety" buying).

Currently, the yield curve is distorted by manipulation by the Federal Reserve (which keeps short-term real rates negative and attempts to suppress long-term rates by buying bonds with "out-of-thin-air" dollars -- "quantitative easing" or QE).

The real yield of any bond is eroded by inflation. The real, inflation-adjusted yield from Treasuries is calculated two ways: by subtracting current inflation rates, and by subtracting the TIPS yield of the same duration. This is often used as a gauge of market inflation expectations.

The real yield of the 10 YT is back to the average pre-crisis range. The current Treasury-TIPS spread shows 10 year inflation expectations of 2.26% and 30 year inflation expectations of 2.50%. This is almost identical to the pre-crisis spread.

In late 2010, the yield of the 30 year Treasury suddenly increased relative to the 10 year (that is, investors were relatively less interested in the 30 year, so its price dropped). This caused the Federal Reserve to begin quantitative easing in October 2010. The ratio of the yields of the 30 year Treasury to 10 year Treasury suddenly dropped, because of the Fed's demand for the 30 Year Treasury. The 30-to-10 year ratio is now back to the post-crisis normal ratio...but gradually creeping up. (In the ratio chart below, multiply the ratio by 10, due to Stock Charts' axis.)$IRX,$US...

I think that the pre-QE2 spike in 30 year Treasury yield is due to investor worries about sovereign default risk, not inflation. The Treasury-TIPS spread was normal, because this concern affects all Treasury debt equally.

With government debt at 10% of GDP and rising fast, it is critical for Treasury to shift durations longer and keep long-term yields down.

In a normal economic recovery, bond prices fall (yields rise), because the stock market is an attractive alternative to investments.

The spike in the 30 year Treasury yield in mid-2010 coincided exactly with the stock market rally.

Once the Fed stops manipulating the Treasury market, the 30 year Treasury yield will spike again, especially if the economic recovery continues.

Because the government will need to finance at higher rates, the debt will spiral upwards. This will exacerbate bond investor worries about sovereign default, since the U.S. debt trend now resembles other nations which eventually defaulted.

This bodes ill for the long-term safety of long-term Treasury bond values. However, in the short term, Treasuries will still benefit from flight-to-safety buying in a crisis.

Wendy (cross-posted to METAR Board)
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