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Yield Curves

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I have been looking over the U.S. treasury yield curve recently using some of the techniques and tools I use for stocks. My best read of the 2s and 10s is that, though the spread could widen from the existing 50-55 bps in the next 1-3 weeks, thereafter we believe the curves are set to flatten - perhaps significantly, bringing the 2/10 spread to 0-20 bps by the end of the summer/beginning of the fall. The 2/10 spread was at its max in August 2003 (at 274 bps) and has been steadily narrowing for the last 21 months. Our individual analysis of the 2s and 10s suggests that narrowing process has the potential to accelerate soon.

You are already familiar with the predictive value of an inverted yield curve: to the degree that the 2/10 spread narrows to 0-20 in the next several months that would increase the probability of a recession in 2006 significantly. This spread number as well as the pace at which it changes will be an important 'follow-on' indicator of decreasing time preferences across the economy that would likely result in significant economic weakness (manifest in consumer and financial sectors most acutely) as well as a perhaps meaningful asset deflation.

Net/net: our models for the stock markets are already saying a significant decline is probable; we've been saying that since January. And now our near-term (next several months) analysis of the 2s and 10s are saying something similar with respect to spreads. The 2/10 spread might well be the next big shoe to drop that will allow us to feel more comfortable with the idea that the deflationary contagion is moving from the stock market to the wider economy.
No positions in stocks mentioned.

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