WATCH FOR STEEPER YIELD CURVES / THE WALL STREET JOURNAL ( HIGHLY RECOMMENDED READING )

HEARD ON THE STREET

FEBRUARY 10, 2010, 5:28 A.M. ET.

Watch for Steeper Yield Curves .

By RICHARD BARLEY

Think the yield curve's steep? If the bond vigilantes get their way, prepare for it to get steeper. While the current Greek debt crisis may be close to some short-term resolution, it's unlikely doubts about sovereign creditworthiness will be dispelled in the longer term. A possible result: longer-dated bonds could be hit hard, while short-dated bond yields might hold steady in expectation the hit to growth from fiscal austerity would lead to continued low rates.

So far, the geography of the crisis has masked this phenomenon: the gap between U.S. two and 10-year bonds, for instance, remains at 2.8 percentage points—the widest it's been in at least 30 years, but no wider than in recent months. Similarly, the U.K. gilt curve has remained steady. Instead, the big move has been in the spread between Greek bonds versus German bonds, rather than in the yield curve of any one country.

But can the U.K. and the U.S., both of which like Greece are running double-digit budget deficits as a percentage of GDP, remain immune from close inspection by the bond markets? Big investors like PIMCO and Schroders have warned that the U.K., in particular, desperately needs a credible fiscal consolidation plan. Ratings agencies have rattled sabers over their triple-A ratings. If bond investors decide politicians aren't doing enough, then yield curves could steepen. Even fiscally solid Germany, where the 2010 budget deficit is just 5% of GDP, might not be immune if a bailout package for Greece ended up moving the focus to euro-zone fiscal consolidation or increased funding costs across the single currency area.

That would give policy makers a challenge. They would need to decide whether higher long-term interest rates were acting as a drag on growth and an incentive for fiscal tightening. Policy makers might then be able safely to leave interest rates low for longer, letting the market effectively do any tightening for them. But a rise in long-term interest rates could also reflect a fear that governments might, rather than taking harsh fiscal decisions, resort to higher inflation to ease their debt burdens. In that case, policy makers would have to raise rates.

This explains why the market is so divided on the timing of monetary tightening—some warn rate increases may come this year already; others argue central banks will be on hold well into 2011. Reading the market runes correctly could be vital.

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