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The Yield Curve Looks Ready to Narrow, May Trigger True Risk-Off Period

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About that rising rate environment thing....

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The excessive increase of anything causes a reaction in the opposite direction.
-- Plato

Let's talk facts, folks. First, inflation expectations have undeniably fallen all year, while the honey badger SPDR S&P 500 ETF Trust (NYSEARCA:SPY) has rallied in an abnormal way, given that equity is not supposed to be a deflation hedge. Second, the Fed is clearly going to have a hard time "tapering" because the threat of tapering causes bond investors to panic, yields to spike, and "tighter financial conditions" which in turn results in no taper. Third, the yield curve is historically steep relative to its own history and relative to inflation/growth expectations. Stocks and bonds have both priced in something that never occurred, as $85 billion per month fails to force reflation in anything except hope.

The 10-year yields briefly cracked 3% a few weeks ago after stock market hours, getting it "out of the way" before dropping fairly quickly since. Is the bond move over, though? I addressed this issue yesterday when I co-hosted Bloomberg from the standpoint of arguing that the yield curve looks ready to narrow again.

Take a look below at the price ratio of the iShares Treasury Bond 20+ Year ETF (NYSEARCA:TLT) relative to the iShares Treasury 7-10 Year ETF (NYSEARCA:IEF). As a reminder, a rising price ratio means the numerator/TLT is outperforming (up more/down less) the denominator/IEF.



This is one way of watching the yield curve. When it is rising, longer-duration bonds are outperforming shorter-duration bonds, signaling deflationary fears and a narrowing of growth expectations. Traditional risk-off periods coincide with a narrowing yield curve, which appears to be likely, based on the far right side of the chart. Taper talk caused a severe overreaction in yields, which scared the Fed. It now appears that the market wants to reverse some of that. For those looking to play bonds for a trade, this now appears to be an interesting spot to position in.

Twitter: @pensionpartners
No positions in stocks mentioned.

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