The Fed and the BoE are going to allow themselves to fall behind the curve as they seek to hold rates low whilst an economic recovery gains traction and begins to absorb some of the spare capacity which has been created by the recent recession (i.e. unemployment falls and manufacturers’ capacity utilisation rises).

We saw the first inklings of how this will play out in practise after last Friday’s US employment report.  A stronger than expected 4th December 2009 report (which showed the unemployment rate falling by 2/10ths and non-farm payrolls essentially unchanged at -11,000, together with the prior two months revised to show 159,000 fewer jobs lost) caused the market to price in a rate hike by the Fed in Q2 2010 and the Dollar rallied on expectations of US rates rising.  However the Fed will probably keep rates on hold for far longer than the market currently thinks and we are going to see repeated attempts by the market to price in a series of rates hikes which will fail to materialise on time as the Fed stays firmly & willingly behind the curve.

So the US and UK yield curves are likely to steepen further as the Fed and BoE deliberately keep rates on hold whilst an economic recovery builds strength and they will want to see their respective unemployment rates much, much lower before they dare to begin hiking rates.  The press may ascribe 10-year Gilts selling off (higher yields) to worries about Labour’s complete unwillingness to sketch out a plan to bring the budget deficit back under control but actually the gilts market doesn’t care about Labour’s economic plans because the view at the moment is that the Conservatives are going to win next May’s general election and it will be their budget plans for 2010-15 which will matter. 

The more likely explanation for higher 10-year yields is that government bonds always sell off when the market scents economic recovery and last Friday’s US employment report hinted towards a sustainable trend of lower unemployment and consequently stronger GDP ahead. This is also why the strong correlation between a weaker Dollar & stronger stockmarkets (which has been maintained since stockmarkets bottomed in March 2009 all the way up until last Friday) now appears to have broken down. Markets are now sensing growing GDP which implies corporates will grow their top line sales (hence higher profits, so the stockmarket rally continues) and growing GDP also implies US Dollar strength after the weakness we have seen in the last 9 months.