Monday, December 28, 2009
Yields on 10-year Treasury bonds are a handy barometer of the market's economic optimism. Yields plunged late last year to 2%—a level not seen since the Great Depression—as the market came to fear that the economy was headed for a severe depression and deflation. Yields are now headed back 4%, which—in my view—is a level consistent with an economy that is only capable of managing meager growth with very low inflation. Yields would have to go well over 4% and approach 5% before I would say that the market's expectation of our economic future was anything close to "normal."
So the market is still gloomy, but not catatonic as it was a year ago. Rising bond yields reflect improving sentiment on the margin, and that goes hand in hand with the Fed moving sooner, rather than later, to reverse its quantitative easing and push short-term interest rates higher. This is not a threat to the economy, this is a natural consequence of the economy doing better than expected. The Fed would need to raise short-term rates to at least 5% before anyone could argue that money was tight enough to threaten the economy. Historically, it has taken one or more years of a real Fed funds rate of 4% or more before the economy succumbs to tight money and slides into a recession.
And since the yield curve today is as steep as its ever been, we know the market is already prepared for significantly higher short-term interest rates over the next few years. The real problem would be if the Fed failed to raise rates in a timely fashion, since that would likely result in higher inflation and eventually another round of tight money and a protracted recession.
Posted by Scott Grannis at 9:54 AM