Futures Outlook - An Excerpt from CRB'S Futures Market Service

U.S. Yield Curve Likely to Stay Very Steep Through 2010

The U.S. Treasury yield curve has steepened to near-record levels due to the twin financial and housing crises. A “steep” yield curve occurs when long-term yields are much higher than short-term yields. The Fed in late 2008 was forced to cut its federal funds rate target to the range of zero to 0.25% in order to rescue the global financial system. In response to the Fed’s extraordinarily easy monetary policy, the 2-year T-note yield is currently at 0.71%, which is just slightly above the record low of 0.604% posted in  December.

Meanwhile, the 10-year T-note yield, which temporarily hit a record low of 2.035% in late 2008, is currently at 3.33, where is it just 42 bp below the 3.75% average seen in 2008 before the financial crisis emerged. The fact that the 10-year T-note yield is only 40 bp below its pre-crisis level attests to the fact that the T-note market believes that things are returning to normal on a longer-term time frame and that the Fed  will not allow runaway inflation to emerge in coming years.

The spread of the 10-year minus the 2-year T-note yield is currently at 263 bp, which is just 3.5 bp below the record high of 266.5 bp posted in July 2003. The yield curve is typically steep during and immediately after a recession when the Fed keeps short-term rates pegged at low levels to stimulate the economy but where the market keeps long-term yields at more normal levels to account for long-run inflation  expectations, which generally run at 2% or higher.

In this cycle, the yield curve is likely to stay relatively high for a longer period of time than in previous recessions due to the severity of the recent recession and the fact that the Fed is likely to keep rates at very low levels to ensure that a doubledip recession does not emerge. Indeed, St. Louis Fed President James Bullard raised some eyebrows earlier this week when he said the Fed may not increase rates until  2012. That statement highlighted the fact that the Fed is likely to maintain a sub-1% funds rate at least into 2011, thus keeping the yield curve steep into 2011 as well.

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