With rates down the curve has flattened considerably. The record levels of steepness that we had earlier this year was a function of the short-end of the curve being anchored near zero, while the longer end was more influenced by creeping inflation concerns and higher commodity prices. Despite the flattening, the current curve at 175 basis points 2-10’s is still steep by historical measures, but the most recent move comes from the market getting ahead of a new form of stimulus being called “operation twist”.

What the market expects the Fed to do is pretty simple. The Fed currently holds a portfolio of Treasury bonds and agency mortgage backed securities. Before any quantitative easing it was a big deal when they began buying bonds because unlike typical monetary stimulus where the Fed brings down short-term interest rates, with Quantitative Easing they began to influence rates further out on the curve to lower longer term borrowing costs. Operation Twist would move the average maturity of the Fed portfolio out even further, by selling shorter bonds and buying longer bonds, to increase their influence on longer term rates while not increasing the total size of the portfolio. Operation Twist is still only speculation at this point, but if it actually happens the curve would probably flatten from its current level.

Inflation expectations have followed yields lower over the last couple months. The volatility in inflation expectations, (up with QE2 in the first half of the year – down with downward growth revisions in the second half) has brought us back to where we were right before QE2 started, which is interesting considering the market is again looking to the Fed for more stimulus.

Have a great weekend.