Thrown for a curve

The sport of baseball is unusual in the extent to which a player's contribution to a particular game, season, and career can be measured through statistics. As such, there is a thriving industry of baseball analysts who evaluate the true worth of present, historical, and indeed prospective baseball players on the basis of their statistical records.

Among this community, one of the more celebrated players of the past forty years in Bert Blyleven, pictured left. Mr. Blyleven was not the best pitcher of the past forty years, but he is one of the most under-appreciated by mainstream analysts and casual fans. Part of the rationale for this is that many of the teams he played for were mediocre, and it's difficult for a pitcher to assemble a winning record with no run support. Then there's the nature of his pitching; Blyleven was a curveball specialist. While he notched up plenty of strikeouts with his wicked "deuce", he also gave up a prodigious number of home runs when his curves were a bit too straight. The treatment of Mr. Blyleven, whose Hall of Fame case is a cause celebre amongst baseball's analytical community, suggests that perhaps curveballs are structurally under appreciated by the mainstream baseball community.

Regardless, the curveballs thrown up recently by the fixed income market have not been appreciated by the financial community. The carnage in short-end yield curves has been messy and bordering on the epic. Rate hikes are now priced in by year-end in each of the G4, according to OIS curves; the price action in LIBOR-based products, such as December short sterling (pictured below) has been gruesome.

So what's going on here? Have markets finally woken up to the secular inflation threat that Macro Man's been banging on about for a year and a half? Perhaps; US 5y/5y breakevens have widened quite sharply over the last couple of weeks.
But even Mervyn King, the uber-hawk, has suggested that there's not a heck of a lot that the BOE can do about inflation in the short term, and indeed that the Bank shouldn't be trying to get inflation back to target in the short run. So if inflation is a legitimate worry, and central banks are constrained from tightening by the economic cycle and credit crunch, surely that's a screaming sign that yield curves should be steepening?

Nope. Yield curves everywhere have flattened, confounding economic analysis and, oh by the way, generating a gazillion dollars worth of losses.
Such a curve ball is hardly unprecedented. If way enter the "way-back" machine and have a look at the last aggressive Fed easing cycle, what do we find? A horrible squeeze higher in 2 year yields in the months following 9/11, with the trough-to-peak rise totalling nearly 150 bps.
Ultimately, of course, 2 year yields traded very substantially lower. It just goes to show that when the market starts throwing curve balls, discipline is important. Far better to wait for the market to hang one of its curveballs and knock it out of the park than to strike out like one of the 3,701 guys that Bert Blyleven dismissed in his career.