Has the US yield curve 'conundrum' simply disappeared?

Alan Greenspan once referred to the flattening US yield curve in an environment of rising US rates as a 'conundrum'. I guess it was frustrating for the Fed to keep hiking rates without having any significant impact on the long-end of the yield curve.

When Greenspan stepped down in January this year, the slope of the US swap curve stood at just 8bps. Today, the 10-year swap rate exceeds the 2year swap rate by over 25bps. So has the conundrum disappeared over-night?

Many reasons have been cited for it, one being the burgeoning foreign exchange reserves of Asian central banks, which to a large extent found their way into US assets. Reserves in Asia, especially China, continue to grow. Neither has the global savings glut vanished. Demand for duration from the likes of pension funds also exists as they look to balance their asset/liability portfolio.

What has however changed is market perception. With oil having traded at $75 and gold rising well above $600, there is some concern that rising commodity prices could slowly begin to feed into long-term inflation. Secondly, with rates in Europe expected to rise by 75bps to 3.25 per cent by the end of the year, with the Bank of Japan expected to hike soon and with Gilt futures now pricing in the possibility of a rate hike in the UK, buyers of US assets are likely to demand higher yields as interest rate differentials narrow. Lastly, any talk that the US rate hike cycle could be nearing a close is likely to see short-term rates fall faster, just as they rose more sharply than the long-end when rates were rising.

But is a peak in Fed Funds a reality given that the US economy is expected to clock in a 5 per cent plus growth rate in the first quarter, with commodity prices at record highs and in the face of a growing constraint on resources?

New chairman Ben Bernanke appears to have provided the market with some food for thought, having clearly stated that at some point in the future the Fed may decide to take no action at one or more meetings.

So what is he really saying? I guess, put very simply, the outlook for US interest rates is as difficult to assess for the Fed as everyone else.

The author is Regional Head of Sales, HSBC Global Markets, Middle East. The views expressed are his own and not necessarily shared by his employer.