The bond market is not worried about the economy

A week ago I argued that there was "no need to fear Fed tightening," because both bond yields and the Fed were reacting to declining risk aversion and an improving economic outlook. My point: higher yields are not a threat to growth, they are a by-product of an improved growth outlook.

This week I change the focus slightly, and look at the behavior of Treasury yields during business cycles. What has happened this year is very typical of what happens as the business cycle matures. The yield curve has flattened somewhat, but it is nowhere near the flatness that typically presages a recession.

The chart above shows the history of 2- and 10-yr Treasury yields. The long secular decline in yields since the early 1980s has been driven by declining inflation, declining inflation expectations, and, more recently, by slower growth expectations.

2-yr yields are equivalent to what the market thinks short-term interest rates will average over the next 2 years. Rising 2-yr yields are thus a sign that the market is ratcheting upwards its expectations for Fed tightening, because the Fed has a very powerful influence on short-term interest rates. 

10-yr yields, on the other hand, are largely driven by the market's expectations for economic growth and inflation. The Fed can influence these expectations to some extent, but not by much. The chart shows that even though the Fed purchased trillions worth of notes and bonds in three rounds of Quantitative Easing, 10-yr yields rose during each episode of Quantitative Easing. Yields rose because the market perceived that the Fed's bond purchases were correctly addressing a problem and thus improving the outlook for growth. Yields fell after QE1 and QE2 because the market realized that the Fed had not done enough to address the world's demand for safe assets, and this threatened the outlook for growth. We now know that QE3 is virtually finished, but yields have only declined marginally, which in turn suggests that this time the Fed has done enough.

Some have suggested that the recent decline in 10-yr yields and the rise of 2-yr yields might be the bond market's way of telling us that a tightening of monetary policy next year could prove debilitating to the economy. But as the chart above shows, the current spread between 2- and 10-yr Treasuries is still quite wide—the yield curve is still plenty steep. The economy has flourished for years with a yield curve as steep as today's. It's only when the curve gets flat or inverted that the economy is approaching trouble.

The chart above shows that every recession since 1960 has been preceded by a severe tightening of monetary policy. Very tight money shows up in high and rising real short-term interest rates (the blue line) and a flattening or inversion of the yield curve (red line). Today both of these indicators remain firmly planted in "easy money" territory.

Conclusion: the bond market is not displaying any concerns about what might happen to the economy when the Fed starts raising interest rates next year.