Steepening Yield Curve Economic Optimism....Or Something Else

WSJ reports on the steepening yield curve,

Economic Optimism in Treasury Yield Curve

By MIN ZENG

NEW YORK—A closely watched gauge in the Treasury-bond market is signaling the U.S. economy may gain more traction.
The spread between shorter- and longer-maturity U.S. government-bond yields has widened to near a record high as longer-dated yields rise on expectations that inflation pressures will revive....

The common theory is that when yield spreads widen, which is when the so-called yield curve steepens, it suggests investors are optimistic about the strength of the economy. They are demanding higher yields in longer-dated Treasurys than in shorter-dated ones in order to compensate for the risk of inflation, which is a main threat to bonds' fixed returns over time.

When yield spreads widen, banks are the big winners because the lower short-dated yields mean they can borrow cheaply to fund short-term obligations while lending out to businesses and consumers at higher rates.
Higher long-dated Treasury yields also help pension funds and insurance companies cover their long-term obligations. The flip side is that higher yields push up mortgage rates. Homeowners' mortgage rates tend to track the 10-year Treasury yield, and higher rates hurt the already-struggling housing market. It also gets more expensive for companies to borrow in capital markets.

A couple alternative  or additional explanations:

• The selloff in long bonds corresponded with the passage of the tax cut extension. While it may spur growth the tax cuts will almost certainly increase the deficit (sorry Mr. Laffer I'm not a believer in your curve. After all the tax cut is really keynesian it is deficit spending or has the same effect, perhaps more efficiently than a stimulus plan... perhaps not.

• So perhaps the bond vigilantes of the Clinton era are back fearing more supply coming on the market pushing down prices and raising yields. This is probably a mixed blessing remember that the bond vigilantes pushed the administration to close the budget deficit. The treasury stopped issuing long term bonds during that period (no need to fund a large deficit) and rates fell.

• The large retail flows into bonds came from investors who were ignorant that it is quite easy to lose money in bonds particularly in the longer maturities I wouldn"t rule out large outflows from the funds pushing  bond prices down.

• \By contrast the natural buyers of bonds pensions, endowments and insurance companies who constantly have new inflows look at higher rates as a welcome respite since the higher rates make it easier to meet their futuere obligations, 

• The otrher group to have a natural benefit from a steep yield cuve  as they borrow short (deposits and cds) and lend long with mortgages. Of course the higher mortgage rates are likely to slow down whatever recovery exists in the real estate market/

• While retail investors likely got burnd with rising long term rates, corporations, as I noted were playing the low long term rates correctly. Those that issued long term bonds throughout the year benefited from record low rates. Unfortunately for the economy they have been using the cash for stock buybacks and dividends not job creating investments.

Of all the arguments for the yield steepening I find the inflation argument the weakest. First off I have faith that signs of economic growth will be swiftly met with contractionry monetary policy.

Mr. Market has expressed an increase in inflation expectations . This cambe seen in terms of the TIPS/Conventional Treasuries doens't indicate a particularly strong forecast of inflation The real yiield on the 10 yr tip  moved up this month from .83 to 1.05% that puts the implied inflation forecast for the next 10 years of 2.83% within the Fed's target inflation rate but quite a good sized move from 2.12% at the beginning of the month.