Inflation and the yield curve

The spread between long-term and short-term interest rates or liquidity premium needs to compensate investors for the obvious risks of lending money over a long period of time.

Let’s use the spread between the 10-year Tnote and the 90-day LIBOR as a proxy for the liquidity premium. How well has it matched inflationary expectations, as measured by the spread between 10 year T-notes and 10- year inflation-protected Treasuries (TIPS)?

The history since the January 1997 advent of TIPS shows the relationship between expected inflation and the liquidity premium to be far looser than we might have imagined. For example, the explosive steepening of the yield curve in 2001-2003 corresponded to a period of meandering inflationary expectations and a stable dollar. Once it became apparent in April 2004 the Federal Reserve would have to reverse its ultra-low interest-rate policy, the liquidity premium narrowed precipitously, but inflationary expectations did not fall apace.

One explanation for these periods of divergence is relative economic growth at the time. Inflationary expectations in 2001-2002 fell partly because of slack capacity.

They failed to decline in 2004-2005 in large part because this very same global slack capacity began to be absorbed by the breakneck economic growth of China and India.