Monday, February 9, 2009

Bond yields continue to bounce

Yields on 30-yr Treasury bonds have surged over 120 bps from their recent, all-time low of 2.52%. Further to my previous post, this is one more example of how the markets are recovering from the airpocket that occurred late last year. Three forces are likely at work here: 1) the approaching avalanche of Treasury issuance needed to fund the mega-stimulus plan that Democrats are hoping will pass this week (be very careful of what you wish for!), 2) the spreading realization (still very much under the radar for most people however) that the economic fundamentals are improving, and 3) the rapidly fading fears of deflation, which are sending nominal Treasury yields sharply higher while TIPS real yields hold steady or decline.

The Fed has said it may buy T-bonds in order to keep mortgage yields low and thus provide support to the housing market. The bond market seems to be challenging the Fed's promise. If I had to bet, I would give the advantage to the bond market. The specter of a central bank seeking to put a lid on bond yields through massive bond purchases is enough to send chills up the spine of any bond investor.

Rather than fearing that higher bond yields may act as an economic depressant, the Fed and Congress should realize that higher bond yields are a sign that the economy is recovering on its own. Fed intervention in the bond market would only exacerbate the rising inflation pressures that are likely to mark the next chapter in the economy's recovery from this crisis.

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