US Treasury Secretary Janet Yellen. Photo: AFP

An off-hand comment by Treasury Secretary Janet Yellen that “issuing longer-term securities certainly seems to make some sense” February 22 aggravated the sharp sell-off in long-term Treasury securities and widened the differential between shorter and longer maturity bonds.

That’s a man-bites-dog story, because central banks engaged in monetary stimulus usually want to keep long rates down. That helps households and corporations take on cheaper long-term debt to buy houses and capital equipment. 

But Secretary Yellen, a former Fed chair, has another problem on her agenda: Financing a government deficit swollen to an astonishing 16% of GDP. Yellen needs the commercial banks to keep buying trillions of dollars of Treasury securities a year, and the banks need a steeper yield curve to make money buying Treasuries. 

Put another way, the United States now resembles Italy, Europe’s basket case, where the main function of commercial banks is to finance the state deficit, while the state hands out subsidies to various political constituencies.

The bond market’s rush out of longer maturities might seem an overreaction to the Treasury Secretary’s passing remark, except for the context: Central banks engaged in monetary stimulus usually do their utmost to keep long rates down, usually by buying longer maturities.

In fact, most of the Treasury’s massive issuance of debt this year came in shorter maturities. That reduced the average maturity of outstanding US government debt sharply, as shown in the following chart from the US Treasury website:

Since the beginning of 2020, US commercial banks have added nearly $2 trillion in government securities to their books, while business loans have fallen. The last time a shift of this magnitude occurred was the depth of the 2008-2009 Global Financial Crisis. 

That isn’t good for the economy; it means that businesses (especially small businesses) are deprived of working capital and Americans aren’t working. Instead, the federal government is sending out subsidy checks. There are 10 million fewer Americans on nonfarm payrolls than there were a year ago. Employment bounced off the bottom, and then ceased to recover.

A steeper yield curve isn’t good for businesses and households, but it is good for the banks, who borrow short and lend long. The greater the differential between the banks (ultra-low) cost of funds and the (rising) amount of interest they earn from holding government securities, the more money they make.

That explains why the prices of bank stocks during the past year have moved in tandem with the difference between short- and long-term interest rates, as in the chart below.

There’s a good deal of chatter in the financial press to the effect that the yield curve is steepening because investors expect more inflation down the road as the economy recovers. This is plainly false.

The bond market has its own gauge of inflation expectations, namely the difference between the yield on ordinary coupon Treasuries, and inflation-indexed Treasuries. That’s the inflation rate (measured by the Consumer Price Index) at which you break even on ordinary Treasuries and inflation-indexed Treasuries. In short, it’s the inflation rate that the market expects.

The difference between long-term and short-term inflation expectations has been shrinking for months. In fact, it’s now negative: The bond market expects less inflation at the 30-year horizon than at the 5-year horizon.

That’s quite the opposite of what an overheating economy is supposed to do. In effect, bond investors think that the rise in near-term inflation is a response to the snapback in oil and commodity prices, a short-lived shock that will dissipate over time.

That is what Fed Chairman Jerome Powell said today, prompting a recovery in US stock prices. There at least the Fed has had it right: Inflation isn’t the issue, as I argued last week. Neither is long-term growth – not with a sugar-high recovery that depends on checks from the federal government while 10 million Americans remain out of work. 

It’s all about the budget deficit, and the banks that have to finance the budget deficit – that, and another couple of trillion dollars of subsidy checks. Buona fortuna, America: We’ve seen this movie before in Italian. Now the Fed will dub it into English.