by Aaron Task
Oh the irony… On the same day third-quarter GDP was revised down to 2.2% from 2.8% previously (and 3.5% in the “advanced” report last month), market participants are discussing a sharp steepening of the yield curve, historically a harbinger of rapid economic growth.
The yield curve – the difference between rates on short- and long-term Treasuries – is at its highest level ever “and signals that investors are expecting a stronger economic turnaround ahead,” The WSJ reports.

A steep yield curve has two major practical ramifications:

It’s a great time to be a banker, part 379: Because banks can borrow from the Fed at short-term rates near zero, higher long-term rates mean even bigger risk-free profits for the industry.
It sucks for the rest of us, part infinity: Because most mortgages and many other types of loans are pegged to long-term rates, a steeper yield curve means a higher cost of borrowing for most consumers and businesses.
The yield curve typically steepens when investors shun long-term Treasuries because they feel riskier assets will do better because of economic growth and when they fear inflation, which erodes the value of fixed-income securities. Before this year, the last time the yield curve was near current levels was 1992 and 2003, i.e. when the economy was emerging from recession and on the verge of rapid growth. Many are drawing the same conclusions from today’s levels.

The yield curve has historically been a better economic forecaster than other market metrics like, say, the stock market. Recall the yield curve inverted in 1999 (meaning short-term rates were higher than long-term rates), correctly forecasting the coming recession even as the stock market continued its bubblicous behavior for several more months.

“It’s different this time” are the most dangerous words on Wall Street. Still, it’s worth exploring why the steep yield curve maybe isn’t signaling sharp economic growth.

By keeping short-term rates at zero “for an extended period”, the Fed is making sure short-term rates are de minimis in order to further aid the banks, as noted above. But because net interest margins are so favorable for banks they’ll have even less incentive to lend, which won’t be good for economic growth going forward.

Meanwhile, there’s additional demand for short-term securities from speculators seeking to shelter profits at the end of a very good year, as well as foreigners seeking to avoid the risks of owning longer-term Treasuries because of fears of further dollar weakness and inflation.

In sum, there’s a lot of demand now for short-term Treasuries, which is pushing prices up and yields down. At the other end of the curve, demand for long-term Treasuries is falling, pushing prices down and yields up. The end result is a steeper yield curve, but not necessarily a robust economy in 2010.

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