Friday, October 9, 2009

10-year yield update

I must admit that I thought yields on T-bonds would be a lot higher by now. Despite the downward drift in yields since last June, I still expect them to move substantially higher, and today I breathed a sigh of relief. I was amazed at how complacent the bond market seemed to be, ignoring inflation signs such as $1000 gold and a falling dollar, and growth signs such as an across the board rise in commodity prices and sharp declines in swap and credit spreads (not to mention the surge in equity prices). My only explanation was that the market just couldn't believe that the economy would grow by any meaningful amount, even though it appeared to have avoided the calamity that was built into prices around the end of the year.

Then Bernanke gave a speech last night in which he seemed to hint that the Fed would be quicker to raise rates if the economy appeared to be on the road to recovery than he had previously hinted. Suddenly the bond market sat up and took notice: my goodness, there are some signs of recovery out there, so maybe it's not impossible that the Fed could raise rates sooner than we thought. Nominal yields are up about 13 bps across the curve as a result, while TIPS real yields are up by about half as much. This confirms that the market is raising its estimate of future economic growth as well as its estimate of future inflation, and both of those are consistent with my belief that until now, the market and the Fed have been underestimating the ability of this economy to grow, and underestimating the risk of rising inflation.

Full disclosure: I am long TBT at the time of this writing.

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