Monday, February 7, 2011

Treasury Yields - What Is Driving Them?

In a prior post, I commented on the move in treasury yields since QE was first mentioned by the Fed in August of 2010.  The very short end of the curve has not budged but as you begin moving beyond one year and especially five years to ten years yields have moved substantially higher.

In the equity markets there is talk of the Bernanke put.  If any market should welcome this free option play it should be the bond market.  After all, the Fed has communicated regularly their goal of low rates for an extended period and the launch of QE to specifically keep rates low.  The Fed has said to the bond market we will put a floor under your security.  For some reason though the bond market has decided to take their ball and play elsewhere.  QE1 did manage to keep yields low when RMBS was being purchased.

There are a number of possible explanations for this move higher in yields.

  • The Fed has encouraged yield chasing and with commodities rising 30% in a matter of months or equities up 25% in five months, why invest in a ten year bond yielding 3%?  It would take you ten years just to match a three month return on a long rice trade.

  • The economy is improving so quickly that bond investors are demanding higher rates as the Fed will be forced to raise rates sooner than currently forecasted.  The problem with this argument is once QE2 was hinted at, rates began moving.  Perhaps the bond market was so confident in the success of QE2 and its ability to stimulate economic growth that bond yields responded immediately.  The results of QE1 combined with trillions in Federal stimulus did little to improve economic growth so why would QE2 be any different? 

  • Inflation is a concern and nominal yields are moving accordingly.  If you look at the TIPS market though (TIPS are inflation adjusted or real yields) inflation does not look to be much of a concern.   The Fed's target for inflation is 1-2% annually so inflation is a concern beyond ten years but not much at just 36 basis points above the upper target.

                 5 Year Inflation - 1.50% in August 2010, now forecasted at 1.98%
                 10 Year Inflation - 1.86% in August 2010, now forecasted at 2.36%
                 30 Year Inflation - 2.18% in August 2010, now forecasted at 2.55%

  • The bond market is beginning to truly question the sustainability of US fiscal policy in the face of growing debt as a percent of GDP.  The question I would raise is why now?  Why not a few years ago?   The reality of investing in US treasuries is you are relying on additional debt to pay back your existing debt. The greater fool theory is the key to this market unfortunately.

The reality behind this move in yields is probably a combination of all of the above.  I was surprised in looking at the TIPS data to see how low inflation expectations truly are.  I think the inflation or deflation argument comes down to one simple truth.  Does QE choke off the remaining final demand in the economy before velocity explodes the money supply?  My vote is the former.  The bond market is sending a signal and one that needs to be watched as it will have direct implications on future monetary and fiscal policy. Let's hope it finally forces some discipline at the Fed and DC.  


1 comment:

  1. Food for thought. Of course Bernanke is not responsible for any inflation anywhere, just asset price rises!