David was talking today (update: but not recommending) about yield curve flattening trades (bets that the difference between long-term and short-term interest rates will fall). The idea would be that, as growth is strong, central banks are likely to raise interest rates, which will increase short-term market interest rates. At the same time, long-term rates would fall because the interest rate increase would make inflation less likely in the future. The nice thing about the trade is that it would also work in a Japan-style scenario where weak growth means that central banks keep interest rates low for a long time, and that long-term interest rates fall.

I do not like the trade. I don’t believe that the US economy is going to be strong enough to warrant increases in interest rates: banks are still capital constrained and not lending, housing investment is not picking up, the temporary stimulus measures (such as cash for clunkers) are ending, and various lunatics in Congress are likely to oppose any further stimulus measures, while other lunatics are unlikely to approve any more assistance for the banks. On the other hand, I do not have a strong conviction that the US is heading for years of Japan-style deflation; at the least, an anaemic recovery that wobbles and later gathers pace is a distinct possibility (people ask what could make the economy grow; the answer is the natural propensity of economies to grow).

The environment is uncertain and it is unreasonable to bet on any one outcome. I am inclined to trade short term interest rate futures only if they reverse their recent steady decline rise, and to trade the range being marked out by the 10-year UK gilt future.

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