How the bond market vigilantes work

The controversy over QE2 continues, but the real action is in the bond market, where bond yields and inflation expectations are moving up daily, if not hourly.

Before QE2 was even a possibility, yields and inflation expectations were declining from May through August. The fuel for this move was the belief that sovereign defaults in Europe would spread contagion through the global economy that could result in a double-dip recession in the U.S. Weaker growth, in turn, would intensify deflation pressures, thus making 10-yr Treasuries an attractive hedge. So everyone piled into 10-yr Treasury bonds, driving their yield down from 4.0% to 2.5%.

Then the Fed floated the idea of QE2 at the end of August, and everything started changing. Traders began speculating that Fed purchases would create downward pressure on the Treasury yield curve out to 10 years. The market began to front-run the Fed, by buying bonds that the Fed was expected to purchase. By October, the market had driven 10-yr yields down to an extremely low 2.4%.

Meanwhile, speculators were also figuring that QE2 could have inflationary consequences. Normally this would have pushed up yields all across the curve, but savvy traders focused their efforts on the long end, because they knew they would be fighting the Fed if they bought the intermediate part of the curve. So the 30-yr bond came under intense selling pressure, and 30-yr yields soared relative to 10-yr yields, taking the 10-30 spread to by far its steepest level ever: 160 bps. For investors making a yield curve play, a popular strategy was to buy 10-yr Treasuries and sell 30-yr Treasuries in a duration-neutral fashion.

The latest twist in this tale began in November, when the FOMC executed the first of its planned $600 billion in purchases of intermediate Treasuries. Two forces were at work: On the one hand, you had a trader's natural impulse to "buy the rumor, sell the fact." The market had been buying 10-yr Treasuries in advance of QE2, and that had been profitable, so now was the time to start unwinding the trade. On the other hand, you had a tremendous hue and cry coming out against QE2. Criticism of the Fed, and dissension with the ranks of the FOMC hadn't been so intense for as long as I can remember. Maybe QE2 would be shut down or cut short? All the more reason to start reversing the trades that had been put into place leading up to November. So the 10-30 part of the curve flattened with a vengeance, and the 2-10 part of the curve steepened dramatically.

Today the steepness of the various segments of the yield curve has returned to the levels that prevailed earlier this year, before sovereign defaults, double-dip recessions, and QE2 arrived on the scene.

What are we likely to see going forward? Two factors are going to figure large in coming months: QE2 and the strength of the recovery. QE2 is likely to continue to fuel inflation concerns, driving inflation expectations higher. Meanwhile, the economy is likely to strengthen at least moderately, with the extension of the Bush tax cuts adding to the forward momentum that has been building for the past several months. The combination of those two forces will very likely result in higher 10-yr yields, and a steeper 2-10 curve, because rising inflation expectations and a stronger economy not only increase the likelihood that QE2 will be curtailed or aborted, but more importantly, they demand a higher level of Treasury yields.

If the market comes to believe that the economy will grow at a more normal rate next year, then by my estimation (laid out in the above chart) 10-yr yields need to be at least 4%. If in addition to that, inflation expectations continue to rise, then we're talking yields of 5% or so.

I think many observers are misinterpreting the rise in yields, thinking that the market is reacting in horror to the prospect that extending the Bush tax cuts will mean an even-bigger federal deficit. They fail to appreciate that federal revenues are already rising at 10% annual pace, and that this is sufficient, if combined with some spending restraint on the part of the new Congress, to reduce the deficit substantially in coming years. Extending the tax cuts won't affect this picture at all; it will most likely increase the economy's ability to generate jobs, expand the tax base, and lift tax revenues.

The stock market appears to be getting a little spooked by the rise in yields as well, thinking that higher yields will shut down the forces of growth. But that's not how things work. Treasury yields are rising because the economy's prospects are improving, and yields are still quite low from an historical perspective. We've seen very strong growth coexist just fine with much higher yields than we have today. It's also the case that while rising Treasury yields make it more expensive for the government to borrow money, they don't necessarily cause corporate borrowing costs to increase. Credit spreads are still quite generous and they can compress further.

There is nothing here that would derail the forces of growth. The only thing of real concern is that Fed policy may eventually unleash the inflation genie that to date has been quite restrained. That could trigger a new round of Fed tightening that would eventually be bad for the economy, but those are concerns we're unlikely to have to worry about for at least the next year or two.