Is the U.S. Treasury Yield Curve Getting Even Steeper?

(This article has appeared on Seeking Alpha and has a lot of followup comments: http://seekingalpha.com/article/198205-why-the-u-s-treasury-yield-curve-should-get-even-steeper )

The yield spread between 10-year and 2-year Treasury notes has widened to record levels. In other words, the yield curve has never been so steep for a long long time. When it is steep, it is predicting future economic growth, usually. Could this time be different? Will it get even steeper?

There are many implications from the steep yield curve. Banks are obviously benefiting from it. Are are hedge funds who have access to low interest funding sources. Savers and retirees who depend on fixed income, however, are out of luck.

To fund deficit spending, the government may need to offer higher yields to investors. On the other hand, some investors seem to find it already attractive to own long bonds, helping the Treasury to raise billions of dollars.

The Fed 's easy money policy and massive federal spending however argues for the possibility of an even steeper yield curve.

The Fed is determined to keep the interest rate at the short end near zero for an extended peiod. Inflation is not yet a concern because capacity utilization is still very low and unemployment rate is still very high. In fact, it is conceivable that the Fed is determined to wait until it succeeds at creating inflation. Inflation will get the economy going, and it will help get the U.S. out from under its debt burden. Moreover, a weak dollar policy also helps to ease the trade deficit.

So for at least 2010, the short end will continue to be ancored down at zero. The long end will depend on two things: (a) investors' expectation of economic growth and (b) inflation.

People talk about these two factors as if they're independent. We think they're intertwined. Higher growth brings about higher level of economic activities, which means higher velocity of money. That's inflationary. On the other hand, higher prices will help jump start business activities by increasing investment and employment. That will help generate growth.

Now throw in the desire of major external Treasury investors to diversify away from their massive holdings, the odds are we'll see an even steeper yield curve.

What precious metal market might be telling us?

Vanguard's precious metal fund (VGPMX) is one of my personal holdings since 2008. It was among the best performing funds of the fund family for 2009, returning 77%. For the first week this year, it shot up 10%, ranked at the very top. But by Feb.8, it had become the worst performing fund in the family, returning -10% YTD.

Gold ETF GLD and gold miner ETF GDX behaved similarly. These are driven by the gold spot price which went from the recent peak above $1200/oz to about $1065/oz as we speak over the last one and half month. The most important factor appeared to be China's announced intention to tighten its monetary policy to comeback over-heated property market and the blewing inflationary pressure. Recent sovereign debt anxiety has added to the dollar strength, helping to bring down the gold price.

What does this reversal tell us? Is precious metal on the secular way down?

The bullish case for precious metal has two sides to it. One dominant thesis is that gold is a good hedge against pending inflation or inflationary expectations. We don't see much inflationary pressure in the TIPs. In fact, economists are expecting deflation in the US as the nation battles the high unemployment rate. How does one square with that observation?

Another theory is that gold is a great store of value, a de facto reserve currency. When US dollar or other major currencies are debased, gold should shine. This argument has gained more support recently. For instance, at the height of the credit crisis of 2008, USD actually strengthened due to flight-to-quality effect (other major currencies such as Euro were even weaker). Gold prices went down briefly as a result, before the global stimulus efforts were kicked into gear. Similarly this last week when Greece's debt crisis resurfaced, dollar strengthened and gold saw a big selloff.

We think the reversal is not something new. The market is telling us what it has been telling us all along: there are deep concerns about future inflation that are coming from global economic growth. That often manifests itself with price increases of commodities. This concern is now compounded by government deficit spending on an unprecedented levels. Market has also been concerned with governments' ability to trim back these spendings when it is time to do it. If there are signs that the governments of major economies will act responsibly, then gold prices have less reason to go up.

When China tightened, the market appeared to be surprised that the pro-growth regime was not as headstrong as many had come to expect. Thus the selloff.

The strengthening of USD due to Euro zone problems may have pulled down the gold price some, but it is only temporary. US deficit spending will either continue to weaken US dollar, or threaten to usher in an era of runaway inflation. Either case is gold bullish. This long term picture may be punctuated by some short term reversals, as we have just seen.