steepening yield curve

Why is the yield curve of US government bonds steepening? Does the movement signal an end to the current recession? Perhaps. Unfortunately there is no way to be sure.

The spread between the long-term and the short-term yields may widen due to several reasons:

(Here bonds should be understood as "US government bonds".)

-Investor start to shun the long-term bonds for their greater sensitivity to interest rate fluctuations.

-Investors switch to the short-term bonds for the greater liquidity their markets enjoy.

-Investors predict that US will run into fiscal problems and funding difficulties in the future, and this will lead to higher future short-term interest rates in the bonds market.

-Investors believe that inflation rate will increase in the future. Therefore they demand higher future short-term interest rates in order to attain the same inflation-adjusted rate of return.

-Investors think that FED believes that inflation rate will increase above the targeted level. (If so, FED will take action and employ monetary policies to increase the future short-term interest rates.)

-FED decides to to pursue a less aggressive monetary policy and tones down its current quantitative easing program. It starts focusing solely on the short-end of the yield curve and removes the artificial ceiling from the long-term yields. (In other words it continues buying short-term bonds and stops purchasing long-term ones.)

-Foreign investors worry about a future devaluation of dollar. (If so, they will ask for deeper discounts while buying US bonds. This is due to the fact that they will presumably convert the money back to their respective home currencies after selling the bonds.)

-Investors believe that the global supply in the government bond markets will increase and US will face stiff competition against other nations. Therefore, in order to attract the desired number of investors, US will have to offer higher short-term interest rates in the future.

-A syncronized sell-off depresses long-term bond prices. (For example, investors may be adjusting their portfolio in order to get more commodities and stock market exposure. Also there may be a movement towards non-dollar denominated markets.)

-Dynamic hedging of mortgage convexity risk may be amplifying the fluctuations in the long-term bond prices. (As mortgage backed securities move into the hands of sophisticated investors and active hedgers, this activity increases.) In other words, higher interest rates on long-term bonds may be a consequence of higher interest rates on callable fixed rate mortgages.

-Investors think that the economy will revert back to positive growth in the near future. (If so, FED will respond by tightening the money supply and increasing the short-term interest rates. Remember that FED aims at sustainable growth with low inflation. It will interfere and calm down the "animal spirits" if growth gets out of control.)