The yield curve is steepening again. Here’s what it means.

Bullish Treasury curve action

Lost in the relief over the rally in US equities today was the price action in US government bonds. And it was good. Even before today, as the middle of the curve inverted, the Treasury curve had been steepening between 2- and 10-year bonds. But today, we saw some of that inversion reverse. And the steepening increased.

Right now, the 1-year to 3-year section of the curve is still inverted with 1-year paper trading at 2.613%, while 2-year paper is at 2.611% and 3-year Treasuries yield 2.603%. But the 5-year sold off steeply today such that the 1- to 5-year inversion has now flipped to 5 basis points of steepness.

Further, the 2- to 10-year spread is back to over 18 basis points from as low as 10 basis points.

My interpretation of the move

Clearly this was a relief rally in equities from a deeply oversold position. But, I have been looking at this as a rotation into safe assets due to increased rate, market, economic, and political uncertainty. Investors were underweight risk-free assets and re-weighted as the year-end approached. So, I don’t see any of this selloff as saying something fundamental about the state of the US economy.

Now that we have had a move back toward risk, I don’t expect another sizable rally in Treasuries until we get an inkling of what the Fed decides to do about a possible March rate hike. And that news will come at the Fed’s January FOMC meeting, scheduled for the 29th and the 30th. This happens to be the same day that we get the Q4 2018 GDP release. And the Fed will have that data in their back pocket as they make a move. The employment data won’t be released until that Friday. But, the Fed should have a good gauge by then of where the data trend is headed.

If we get good data, it should increase the possibility of a March rate hike. But, because the Fed’s reaction function is now highly leveraged to financial conditions, it’s not clear what that will mean in terms of a market reaction and the reflexivity of that reaction’s feedthrough into the Fed’s timetable. We will just have to see how the markets perform over the next month. My baseline is for the Fed to now pause until at least June.

If the Fed signals a pause through June, I am not expecting the curve to invert. And as a market signal, that would suggest that the real economy upturn has room to run through all of 2019, putting a floor under equities.

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