Thursday, January 22, 2009

Bond yields are bouncing

Yields on 10-year Treasury bonds are up over 50 bps from their recent year-end (and essentially all-time) low. Does this reflect a lessening of fears (less demand for risk-free assets) or new fears of an upcoming avalanche of bond sales to finance the mega-stimulus package being put together in Congress?

Short-term Treasury yields (e.g., 3-month T-bills, 2-year Treasuries) haven't gone up nearly as much as bond yields, so the demand for safe-haven assets hasn't changed that much. Gold is even down a little since the end of the year, while the dollar is up. The answer can be found in the TIPS market, where real yields are flat to down since the end of the year. With Treasury bond yields rising but TIPS real yields flat to down, the wider spread (i.e., the breakeven inflation rate) tells us that the rise in Treasury yields is being driven by rising inflation fears. The market is expecting somewhat less deflation in the near term, and somewhat more inflation in the longer term. Still, the breakeven spread on 10-year TIPS is only 0.6%, meaning the market expects the CPI to average 0.6% a year for the next 10 years. That's pretty tame, but it's higher than the 0.1% we saw at year-end.

So you might say that the bond market is not yet concerned about the borrowing implications of the stimulus package, but it is beginning to get concerned about the inflationary implications of the Fed's quantitative easing program.


Jon S. said...

So with the breakeven spread on 10-year TIPS rising a bit, do you still recommend buying TIPS now? I imagine the answer is yes given the likely large inflationary impact of the Treasury-Fed-USG monetary and spending actions.

Scott Grannis said...

Jon: I think TIPS are still a good bet, but I would emphasize shorter maturities. What's happening now is what I expected to see: rising inflation expectations are bad for Treasuries and good for TIPS. All yields could rise, but nominal yields are likely to rise much more. TIPS could take a hit as real yields rise (mostly at the longer end of the real yield curve) but eventually they pay off big as inflation comes in above expectations.