The yield on 2-yr Treasuries is once again at rock-bottom levels (0.36%). This yield is a window to the market's expectations for Fed policy, since it can be equated to the expected average Fed funds rate over the next two years. With Fed funds currently at a mere 0.1%, the market obviously doesn't expect much in the way of Fed tightening over the next two years. Those expectations, in turn, flow directly from the market's collective belief that the economy is going to be dreadfully weak for a long time, thus forcing the Fed to remain ultra-accommodative. Weak growth and low yields, in other words, go hand in hand; as the above chart illustrates.
Many observers argue that the extremely low level of short-term Treasury yields is also a sign that the market expects very low inflation or deflation, but the chart below shows that in fact just the opposite is true. The bond market's inflation expectations have been on the rise, as reflected in a steeper slope between 10- and 30-yr Treasuries, and a rise in the 5-yr, 5-yr forward expected inflation rate that is embedded in Treasury and TIPS prices.
The message of the bond market also illustrates the policy conundrum that confronts the Fed: despite the most accommodative monetary policy ever, the economy is refusing to respond. The knee-jerk reaction of bureaucrats and politicians is to apply yet more stimulus when stimulus fails to work, but we've now had several years of super-accommodative monetary policy and massive fiscal spending stimulus, to no apparent effect. All we have to show for this exercise in public sector hubris is rising inflation expectations and moribund growth expectations. Which is not surprising to me, since as a supply-sider I have always thought that growth can only come from hard work, investment, and entrepreneurial risk-taking. The proper role of government is not to direct the economy's efforts, but to provide for essential services, uphold the rule of law, protect private property, and protect the purchasing power of the currency, among other (limited) things.
So the right thing to do is not to do more of the same, but to reverse course. Tighter monetary policy would reduce inflation expectations, strengthen the dollar, punish the gold and commodity speculators, and restore investors' confidence. Reduced government spending would free up resources for the private sector to exploit and increase investment, since it would automatically reduce future expected tax burdens—and increase the expected after-tax return to risk-taking.
The bond market is trying hard to send its message to Washington. Is anyone listening?