Reading the bond market tea leaves shows that bond market is rationally reflecting an improvement in the economic outlook, rather than any deterioration. This in turn suggests that the equity market selloff is overdone.
The chart above illustrates the biggest change to hit the bond market of late: a sharp rise in 5-yr real yields on TIPS. Since the beginning of April, 5-yr TIPS real yields are up over 70 bps, and that's a big deal.
The chart above compares the real yield on 5-yr TIPS to the 2-yr annualized real growth of the U.S. economy since 1997. As I've argued before, real yields on TIPS tend to track the market's expectations for economic growth. Real yields in the past two years have been negative because the market has been extremely concerned over the possibility of zero or negative growth going forward. It only makes sense to buy TIPS with a negative yield—thus assuring a loss of purchasing power—if you are really concerned that returns on risky assets could be much worse. The recent rise in real yields tells me that the bond market has now become less pessimistic about the prospects for U.S. economic growth, and that same change in sentiment can be found in Fed governors' recent statements. We aren't seeing more optimism, we are seeing less pessimism. The risk of bad things happening has declined, so it is less imperative for the Fed to continue its asset purchases.
The above chart shows 5-yr nominal yields on Treasuries and 5-yr real yields on TIPS, as well as the spread between the two—which is equivalent to the market's expected average annual inflation rate over the next 5 years. Real yields have risen much more than nominal yields, which have barely budged, and that is the result of declining inflation expectations, which are now down to just under 2%, only slightly below the 2.08% average of the past 16 years. Nothing scary at all here: inflation expectations have moderated a bit, and concerns over future economic growth have also moderated a bit. That change in sentiment can also be what's driving gold prices down from exceptionally high levels.
As the above chart shows, long-term inflation expectations have also moderated a bit, but they remain absolutely normal at 2.3%, considering that the annualized increase in the CPI over the past 10 years has been 2.4%. Nothing scary here: inflation expectations remain "well-anchored," as the Fed is wont to say, and there is no sign of deflation concerns either.
The above chart of the spread between 10- and 30-yr Treasury yields is a good measure of the slope of the yield curve, which remains just about as steep as it has ever been. A steep yield curve is a classic sign of a market that expects short-term interest rates to rise in the future, and as a corollary, a sign that the market considers the Fed's current monetary stance to be very accommodative (easy money today almost guarantees that monetary policy will have to tighten in the future). If the bond market were worried that Fed tightening could threaten the economy, then the yield curve would be a whole lot flatter.
By the way, the above chart also shows that the Fed's efforts to flatten the yield curve have not succeeded at all. As I explained last week, when a central bank's massive bond purchases produce a counter-intuitive result, that is a very good sign that monetary ease is working.
Meanwhile, high-frequency data such as weekly claims for unemployment continue to be consistent with an economy that is growing. Nothing to worry about here.
As the above chart of bank reserves shows, the magnitude of the Fed's latest round of asset purchases has been quite modest compared to what it was with QE1 and QE2. Tapering its purchases beginning in a few months will be equivalent to the Fed adding fewer drops to a relatively full bucket.