What the Yield Curve is Telling the Fed?

Real Yields and Breakeven Inflation Expectations are Rising

The Fed should be worried. The recent aggressive steepening of the yield curve has been caused by a combination of both rising real yields and rising inflation expectations. A quick check of the implied break-even inflation rate of the 10 Year TIPS versus 10 Year Notes shows that inflation expectations have risen from 0.11% per annum at the end of the year just after the Fed started its quantitative easing to 1.6% per annum. While this is still a modest level of inflation, the rate of increase must be worrying and will likely restrain the Fed from capping nominal yields as many were expecting. With the Fed restrained in its purchases of governments and mortgages, there is nothing to keep yields from spiking higher with a subsequent steepening of the yield curve. Morover, TIPS also show that not only have nominal yields been rising but real yields have also risen as risk aversion wanes. Eventually, rising real yields caused by excessive government issuance of debt may choke off any private sector economic rebound.