Monday, October 26, 2009

Thoughts on Treasury yields

The first chart gives you the historical context for Treasury yields, and the second chart focuses on the recent action. When the 10-yr Treasury hit 2% at the end of last year, that was a sign that the market was convinced that we were in for a huge depression and deflationary environment. The world was so desperate for the safety of T-bonds that yield was almost irrelevant.

Since then, the reality has been much better than expected. The simple fact that the economy has avoided a depression is probably enough to explain why stocks and Treasury bond yields are sharply higher. Yields are still relatively low from an historical perspective, however, and this is one reason why I have been saying that the market is still relatively pessimistic about the future. No one is ready to believe that we will have a normal recovery (Pimco's "new normal," which calls for a future of very disappointing growth, is all the rage these days). Everyone is worried about the deficit, about big and bigger government, and about higher taxes. Many worry that the Fed won't tighten, that inflation will be huge, and that the dollar will collapse. Others worry that the Fed will tighten, and that this will kill the economy. There is no shortage of things to worry about these days, and that is a good sign that the stock market is not yet in "bubble territory."

If Treasury yields move above 4%, then that would be a sign that the market was buying into the notion of a decent, but not spectacular, recovery. Higher yields would most likely go hand in hand with the beginnings of a Fed tightening, and the Fed is not going to tighten until they are confident the economy is recovering. If Treasury yields move back to 5%, that would be a sign that the economy was doing pretty well, and/or that inflation was expected to move higher.

In short, Treasury yields are a decent barometer for how optimistic the market is about the economy's future prospects. The higher they go, the better things will be.

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