On previous occasions we have pointed out the yield curve spread (US 10yr - 2yr yields) as a barometer of the Fed's monetary policy. Wide readings reflect abundant liquidity where financial institutions can borrow cheaply at the short end of the curve and lend for a better rate at the longer end. Values below 0 have acted as a reliable lead indicator of US recessions, often by a significant amount of time, for at least the last 30 years. (Also see Comment of the Day on May 23rd)


Abundant liquidity in 2009 helped to support stock market rallies globally. >From late 2009 Asian central banks, led by China and Australia, were already tightening monetary policy, albeit from a very low base. India and Canada's spreads turned decisively downwards in early 2010. Yield curve spreads for the USA, UK and the Eurozone remained at elevated levels throughout 2010 and only began to trend lower from early this year. The pace of contraction for all three has increased over the last two months.

India and China have implemented the most severe monetary tightening as measured by these spreads. This has been in response to inflationary pressures stoked primarily by commodity prices. Wage pressures in China are an additional consideration. India's spread has returned to 0 and China's is currently down to 15 basis points from 200. Both of these spreads represent headwinds to growth at current levels as officials attempt to squeeze inflation out of the system. They are also the two countries with the greatest ability to ease policy in the event of economic deterioration.

The Eurozone's sovereign debt and banking sector problems remain the focus of investor angst. In order to illustrate the extent of monetary tightening experienced by some of the more debt ridden countries I created yield curve spreads for Greece, Ireland, Portugal, Spain, Italy, France and Belgium this morning. These can now all be found in the Spreads & Overlays section of the Chart Library.

The spread between the Greek 10yr and 2yr has sunk to -4000 basis points. This is an apt description of the country's economic travails and reflects widespread speculation that a default is unavoidable. Ireland's corresponding spread surged briefly back into positive territory following the July announcement of a lower interest rate on its bailout loans but has subsequently deteriorated. Portugal's spread bounced less and has subsequently fallen more.

Spanish, Italian, French and Belgian spreads have not fallen below 0 but all remain on a downward trajectory. This corresponds with the narrower spreads over German Bunds for these countries than for Greece, Portugal and Ireland.
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These spreads help us to identify where the problems lie but also where the next potential source of money supply exists. Quantitative easing by any or all of the USA, Eurozone, UK, Japan and Switzerland are potential outcomes to the developing situation. To what extent this is feasible given the debt situations evident in these countries remains debatable. China and India were among the first to tighten monetary policy and have therefore also reloaded the "interest rate gun" more than other countries. A move to monetary accommodation by these countries could act as a catalyst to improve investor sentiment.