This metric suggests there's an economic boom ahead — and possibly inflation

As Washington squabbles over stimulus, the bond market is already counting on lots of fiscal spending and an economic bounce back. In an extreme case, inflation might be a risk.

The metric the bond market is watching is the Treasury yield curve, or the difference between rates on various maturities, now at its steepest level since May 2017.

A steepening curve is typically viewed as a positive sign for the economy, the stock market and corporate earnings, while a flattening one is a warning for economic weakness.

The widely watched yield curve shows the difference between short- and long-term interest rates.

In this case, looking at the 2-year yield, now at 0.11% and the 10-year yield at 1.12%, the spread is 1.01 and edging higher with the rising 10-year yield. Rates move opposite price.

“It’s being driven by the fact that policy, fiscal and monetary, is allowing there to be stronger economic growth for longer, without the Fed getting in the way, and that basically is allowing the economic cycle to extend further into the future,” said Jim Caron, head of global macro strategies on the global fixed income team at Morgan Stanley Investment Management.

There are expectations of rising inflation, and this is being priced into the market, he said.

“It’s really about having an economic boom, allowing policy to support that boom,” said Caron. “That’s the key driver of why the curve is steepening.”

The curve is also steepening as some of the pessimism about Covid-19 is lifting and vaccines are rolling out, said Mark Cabana, head of U.S. short rates strategy at Bank of America.

“The acute focus on downside risks may be fading slowly, and who knows exactly what it will do in six months, but I think the market is realizing some of the worst-case scenarios aren’t likely to be as severe,” he said.

Cabana said Bank of America recently raised its 10-year yield forecast to 1.75% by year end, from 1.5%.

“It’s due to the belief there will be fiscal stimulus,” he said. “That it’s going to be highly supportive of economic growth.”

“It’s going to improve longer-run growth and inflation expectations, and the market over time will be less focused on downside risks and will focus on upside risks,” Cabana added.

The market is also focused on the Biden administration’s proposed $1.9 trillion Covid relief package, which is expected to gain approval in a whittled-down form. But it is also expected to be followed by more spending, and it comes on top of a recent $900 billion Covid package.

“Is it a trillion or more than a trillion? It’s somewhere in that neighborhood, all in a year where we’re expected to get good economic growth, but we need good economic growth next year, too,” Caron said.

“The goal is to close the output gap so we make up for last year’s loss and get back to trend,” he added. “This round of stimulus — whenever it gets passed — isn’t the last one.”

The market is not yet pricing the expected debt increase from that spending, but rather the potential economic impact of the relief, Cabana said.

The yield curve steepening dovetails with other data showing improvement in the economy, according to James Paulsen, chief investment strategist of The Leuthold Group.

“I think it’s a pretty decent signal for the economic recovery,” he said.

“I personally think we might have GDP growth of 6% to 8% this year,” Paulsen added. “Inflation is part of it.”

The average forecast of economists for 2021 growth is 5% in the Moody’s Analytics/CNBC Rapid Update.

If inflation gets too hot, that could turn into a negative for stocks, and it would crimp corporate earnings by pressuring margins, Paulsen said.

On Wednesday, the 5-year breakeven inflation rate, a Treasury market metric of inflation expectations, was at 2.30, the highest since April 2013. That means market pros expect inflation to average 2.3% over the next five years. The measure compares the 5-year Treasury yield to the TIPS note of the same duration.

“It’s a lot compared to where interest rates are,” said Peter Boockvar, chief investment officer at Bleakley Advisory Group. “The question is, does the market start to care. Obviously, it hasn’t cared yet. I think it’s the biggest risk.”

The Fed has said it would keep interest rates low for a long period, continue its bond buying and allow inflation to move in an average range that could rise above its 2% target without triggering a rate hike.

Cabana said the Fed would see the rising inflation expectations as positive.

“It’s telling you this is the type of rate rise the Fed wants to engineer. Higher expectations for growth and inflation,” he said. “If the Fed is looking at this, they see it as a healthy steepening.”

Bond strategists say fiscal policy is helping to steepen the curve this time.

The last time the spread between the 2-year and 10-year yields was at this level was when Donald Trump was in the White House for just a few months and the market was still anticipating tax cuts.

But the 2-year was at 1.26% and the 10-year was at 2.27%, and the yield curve was flattening from a steeper level.

“The economy finally was recovering from the financial crisis,” said Michael Schumacher, head of rate strategy at Wells Fargo. “People were thinking about bullish economic policies. There were more signs of growth and people were talking about the Fed tightening.”

Caron of Morgan Stanley said the curve doesn’t usually steepen with longer end rates rising — that is, 10-year rates and beyond. When it does, it’s often followed by a negative period for markets.

That’s because when the long end rates rise, the Fed is usually ready to raise rates and that slows down the economy.

This time around, the Fed will stay on hold and the government is likely to spend money to help a rising economy rise even more, Caron said.