Wednesday, January 5, 2011
Treasury yields and equity prices are facing upward pressure as the economic news gets better. Bond yields and equities have been moving more or less in tandem for most of the past year, and both have been good indicators of sentiment regarding the strength of the economy (which is not unusual at all). Deflation fears have also played a role, as suggested by the bottom in both yields and equities in late August, just before the Fed first floated the idea of another round of quantitative easing; a concerted QE2 effort to vanquish deflation has succeeded, and that has helped lift the economy. As deflation fears are replaced by rising inflation expectations (the 5-yr, 5-yr forward breakeven inflation rate embedded in TIPS has risen from 2.0% last August to 2.9% today), and as double-dip expectations are replaced by stronger-than-expected economic news (e.g., declining unemployment claims, strong auto sales, solid ISM numbers, a blowout ADP report, and rising commodity prices), bond yields and equity prices are rising.
The forces of recovery have been building for 18 months, and they are now being reinforced by rising confidence, which in turn has been boosted by a very favorable change in the fiscal policy climate. Despite the magnitude of QE2, I think its effects have been mainly limited to quelling deflation fears rather than directly boosting growth. After all, there still is no sign of any outsized growth in any of the money supply aggregates, and QE2 can hardly claim to have lowered long-term borrowing costs for anyone. We now have a virtuous cycle at work which will be very difficult to derail. Higher bond yields won't kill growth because they are the by-product of stronger growth.
Full disclosure: I am still long TBT and equities at the time of this writing.
Posted by Scott Grannis at 10:18 AM