Beware the flattening

The U.S. yield curve is definitely trending flatter here. One month ago 5-yr rates were at 3.31% and 30-yr rates were at 4.85%. Now they are at 3.56% and 4.91%, respectively. A 19 basis point (bp) flattening. Most of the shift came on the day of the FOMC meeting and the rest is happening this morning. The markets are changing their expectations for the Fed Fund's rate while keeping their long-term expectations for both the economy and interest rates relatively fixed.

Yesterday Fed Gov. Olson Spoke and the most striking part of his speech to me was the comments he made on real interest rates. After noting that the overnight rate remains accommodative he went on to say, "The nominal federal funds rate is currently 2 percent, a level that, using standard measures of core consumer price inflation, implies a real funds rate that is just above zero--considerably lower than the long-run average of about 2-3/4 percent." Nobody is expecting a Fed Funds rate of 3.75% anytime soon, not the Fed and certainly not the markets but that is the rate his comment implies. I was surprised his remarks did not have more of an impact on bonds yesterday and we may end up with a when-are-they-going-to-stop-hiking-panic in the short-end eventually. Not even close yet but the short-end is definitely reacting.

Even without a panic I think the treasury market will at some point steepen back out as people begin to find a 4% 5-yr rate attractive. Could take a while to play out as the market's belief in a low overnight rate is based in the belief in a weak economy. These Fed comments should be telling markets that they don't perceive the same need for stimulation.

This last point is also the only way to reconcile the strength in stocks with a curve flattening. Flattening is a sign of slowing growth and by keeping the long end low the bond market is not showing the same respect for the economy's strength (or even fear of inflation / stagflation) that the equity market is. In March of '03 the bond market was proven wrong and I think they will be here as well. I have absolutely no doubt that the Fed will avoid deflation and I have a growing faith in the U.S.' ability to export its way back to balance.

Until the Fed starts to give signals that rates are no longer accommodative I think it makes sense to be short bonds. The flattening is making me see the long end as vulnerable to a sharp move higher (yields) like the moves in the Spring of both '03 and '04.

position in TLT options.