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How the Bond Markets React 01.25.05
Far from Over
A lot of talk recently has looked at the slope of the Treasury yield curve as an indicator od whether the Federal Reserve Board will continue to raise rates, whether money supply will be affected, and how it will ultimately effect the economic growth.
The Treasury yield curve has flattened because short term rates have gone up while the long term rates have not. The distance between the two is looked to as an indicator of monetary policy. Mr. Greenspan has suggested, and the release of the Fed minutes from December affirm, those short term rates will continue to rise.
The concern is deepened by the fact that economic growth seems to have slowed considerably - even if the pace wasn't all that torrid. There were optimistic spikes during 2004 but many believe that growth in the GDP will slow to 3% or worse. While GDP has its own set of problems impacting it, the rate set by the nation's top bankers is not the least among them.
Money supply has remained steady while those rates have risen. This constant source of readily available cash has the fixed income market wondering whether the pace of the rate hikes will remain constant or accelerate. Greenspan's language, as transparent as he is capable of getting, points toward a surprise-free upward movement. But I'm not so sure a quarter point here, a quarter point there, will achieve what they are trying to do.
Economic growth will slow as a result of this flattened curve impacting corporate profitability. This is due to the gradual disappearance of the carry trade - a method of borrowing at a lower rate and reinvesting the money where the yield is higher. Six months ago, the yield curve between the Two-year Treasury and the more intermediate Ten-year Treasury was over 2% or in the jargon of the market, 200 basis points. A basis point is 1/100th of a percentage point. That gap has now narrowed to 99 basis points effectively eliminating the carry trade.
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