What Message is the Yield Curve Sending?

If one observation can be used as a proxy for monetary liquidity, it's the yield curve - the relationship of long-term & short-term interest rates.  The steeper the yield curve, the more that the Federal Reserve is teasing the banks and investors into taking more risk.  A steep yield curve ALWAYS occurs at a time when the animal spirits that drive a healthy economy are totally doused.  Here's our daily chart on the yield curve.

You can see how the tightening of the liquidity was occurring from 2004 to 2007 as Greenspan was trying to get power back from the shadow banking system that was levered up to its hilt.  Finally in 2007, as Warren Buffet says, "When the tide goes out, the skinny dippers get exposed," so the tide was definitely out and the leverage in the system began to be squeezed out.  Bernanke's Fed started to react, but when the dam broke in 2008, they poured fuel on the dying embers trying to restart any fire.  Our Monetary Composite moved to its most bullish state of M1 at that time, pegging out the top of that range just as it had done in 1993 as that economy failed to recover.

It is not bullish when the yield curve is getting steeper, but it is a powerful fore-runner of better days ahead.  It is bullish when you see it high and then starting to move lower.  That is exactly where it was in 1995-1996 and where it is today.  If I am reading the economic tea-leaves right, this downward sloping line on the yield curve and the normalization of our Monetary Composite into the M3 - M4 range (it's at M2 today) should occur in the next two years.  You can see the basing action now in the yield of the 10-Year T-Note.

It is my guess that this yield will move up to the 3 1/2 - 4 1/2% level in the next 2-3 years.  This will be a very healthy sign for the economy.

Don Hays

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