Yellen and the Yield Curve

Confirmation hearings for Janet Yellen in the Senate have begun. When confirmed she will succeed Ben Bernanke as Chairperson of the Federal Reserve. There was talk of a filibuster over unrelated political issues, but with a recent rules change in the Senate, Yellen’s confirmation should be relatively smooth.

Ms. Yellen is probably the best candidate for the job and enjoys the most bipartisan support. She will take over one of the most powerful positions in the world with the ability to control the balance sheet and supply of US dollars.

Ms. Yellen’s testimony confirms that she will likely continue the “dovish” policies of Mr. Bernanke, which has favored an easy monetary stance. Her standard for beginning to raise interest rates and stopping the asset purchases (the “taper”) appears to be a lower unemployment rate and higher levels of inflation.

There will be some intrigue each year as different Fed members rotate into voting positions. The Federal Open Market Committee has 12 members and the Reserve Bank presidents take turns filling four voting member positions. Dallas Federal Reserve President, Richard Fisher, will join the voting members in 2014 and has been more hawkish, favoring more restrictive monetary policies.

To illustrate how interest rates are reacting to Yellen’s upcoming confirmation, we can use the US yield curve as an indicator of market reaction.

The yield curve plots interest rates, or yield, of bonds with different maturities, from very short term (a few months) to long term (30 years). Below are two illustrations. The curve on the left is a normal or “positive” yield curve, where short term bonds are earning lower yields than longer term bonds. The curve on the right is an inverted or “negative” yield curve, where short term bonds have much higher yields than long term bonds.

Why is this important?  Changes in the shape of the yield curve can tell us what the bond market expects in terms of economic growth or contraction.

We have seen the yield curve steepen greatly over the last few months. This means that short term interest rates have come down relative to long term rates, increasing the differential between them. This is a positive for folks that borrow at short term rates and lend at long term rates since they will make more money. It tells us that the market does expect a “taper” from the Fed, but there is not an expectation for them to raise short term rates anytime soon.

Overall, the steepening yield curve is a positive sign for the market’s confidence in a continuing economic recovery and support from the Fed, even as it begins reducing the flow of easy money into the system. But it also indicates that the market is building in more inflation expectations into the next five to ten years. We will see how well Yellen walks the tightrope between encouraging a slow growing economy while keeping inflation in check.