Calafia
Beach Pundit
submits:
The controversy over QE2 continues, but the real action is in
the bond market, where bond yields and inflation expectations are
moving up daily, if not hourly.
Before QE2 was even a possibility, yields and inflation
expectations were declining from May through August. The fuel for
this move was the belief that sovereign defaults in Europe would
spread contagion through the global economy that could result in a
double-dip recession in the U.S. Weaker growth, in turn, would
intensify deflation pressures, thus making 10-year Treasuries an
attractive hedge. So everyone piled into 10-year Treasury bonds,
driving their yield down from 4.0% to 2.5%.
Then the Fed floated the idea of QE2 at the end of August, and
everything started changing. Traders began speculating that Fed
purchases would create downward pressure on the Treasury yield
curve out to 10 years. The market began to front-run the Fed, by
buying bonds that the Fed was expected to purchase. By October, the
market had driven 10-year yields down to an extremely low 2.4%.
Click charts below to enlarge
Meanwhile, speculators were also figuring that QE2 could have
inflationary consequences. Normally this would have pushed up
yields all across the curve, but savvy traders focused their
efforts on the long end, because they knew they would be fighting
the Fed if they bought the intermediate part of the curve. So the
30-year bond came under intense selling pressure, and 30-year
yields soared relative to 10-year yields, taking the 10-30 spread
to by far its steepest level ever: 160 bps. For investors making a
yield curve play, a popular strategy was to buy 10-year Treasuries
and sell 30-year Treasuries in a duration-neutral fashion.
The latest twist in this tale began in November, when the FOMC
executed the first of its planned $600 billion in purchases of
intermediate Treasuries. Two forces were at work: On the one hand,
you had a trader's natural impulse to "buy the rumor, sell the
fact." The market had been buying 10-year Treasuries in advance of
QE2, and that had been profitable, so now was the time to start
unwinding the trade. On the other hand, you had a tremendous hue
and cry coming out against QE2. Criticism of the Fed, and
dissension with the ranks of the FOMC hadn't been so intense for as
long as I can remember. Maybe QE2 would be shut down or cut short?
All the more reason to start reversing the trades that had been put
into place leading up to November. So the 10-30 part of the curve
flattened with a vengeance, and the 2-10 part of the curve
steepened dramatically.
Today, the steepness of the various segments of the yield curve
has returned to the levels that prevailed earlier this year, before
sovereign defaults, double-dip recessions, and QE2 arrived on the
scene.
What are we likely to see going forward? Two factors are going
to figure large in coming months: QE2 and the strength of the
recovery. QE2 is likely to continue to fuel inflation concerns,
driving inflation expectations higher. Meanwhile, the economy is
likely to strengthen at least moderately, with the extension of the
Bush tax cuts adding to the forward momentum that has been building
for the past several months. The combination of those two forces
will very likely result in higher 10-year yields, and a steeper
2-10 curve, because rising inflation expectations and a stronger
economy not only increase the likelihood that QE2 will be curtailed
or aborted, but more importantly, they demand a higher level of
Treasury yields.
If the market comes to believe that the economy will grow at a
more normal rate next year, then by my estimation (laid out in the
above chart) 10-year yields need to be at least 4%. If in addition
to that, inflation expectations continue to rise, then we're
talking yields of 5% or so.
I think many observers are misinterpreting the rise in yields,
thinking that the market is reacting in horror to the prospect that
extending the Bush tax cuts will mean an even-bigger federal
deficit. They fail to appreciate that federal revenues are already
rising at 10% annual pace, and that this is sufficient, if combined
with some spending restraint on the part of the new Congress, to
reduce the deficit substantially in coming years. Extending the tax
cuts won't affect this picture at all; it will most likely increase
the economy's ability to generate jobs, expand the tax base, and
lift tax revenues.
The stock market appears to be getting a little spooked by the
rise in yields as well, thinking that higher yields will shut down
the forces of growth. But that's not how things work. Treasury
yields are rising because the economy's prospects are improving,
and yields are still quite low from an historical perspective.
We've seen very strong growth coexist just fine with much higher
yields than we have today. It's also the case that while rising
Treasury yields make it more expensive for the government to borrow
money, they don't necessarily cause corporate borrowing costs to
increase. Credit spreads are still quite generous and they can
compress further.
There is nothing here that would derail the forces of growth.
The only thing of real concern is that Fed policy may eventually
unleash the inflation genie that to date has been quite restrained.
That could trigger a new round of Fed tightening that would
eventually be bad for the economy, but those are concerns we're
unlikely to have to worry about for at least the next year or
two.
Disclosure:
No positions
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