Wednesday, June 29, 2011

The bond market hits a welcome downdraft

Just five days after I posted that "with 2-yr yields and confidence in the future at record lows, the potential rewards to being optimistic have almost never been better," bang: Treasury yields have shot higher, reducing the price of 10-yr Treasury bonds by 2.1% while wiping out two thirds of a year's worth of coupon yield, and equities are up over 3%.

The most visible trigger for this remarkable turnaround is progress towards avoiding a Greek default, but I suspect there are other factors at work as well. I note that the breakeven inflation rate on 5-yr TIPS has jumped by 21 bps in the past five days, as nominal yields have risen 34 bps and real yields have risen by only 12 bps; this signals that half of the rise in nominal yields is due to rising inflation fears, while the other half is due to stronger growth expectations. I note also that crude oil futures are up almost 5% in the past five days, and the Vix index has dropped almost 18%. All of this leads me to the conclusion that, as I suspected, the market was depressed more by fear than by fundamentals.

What it all boils down to is this: Treasury yields are a good barometer of the market's growth expectations, and the market's Phillips Curve logic makes growth and inflation expectations move hand in hand. Yields have been trading at very low levels, suggesting that the market had become deeply pessimistic about growth. Higher yields are thus an excellent sign that the outlook for the economy is improving. Higher yields faster, please.


TradingStrategyLetter - Weekly Summary said...

Becareful what you wish for.
An interest rate 'shock' would more than likely cook the 'golden goose!'
More than likely a lower bond market will be interpreted as major borrowing and monetary failures.
A 'normalized' rate structure of 5-7.5% for 10yr money implies a 20% lower S&P IMO.

Benjamin Cole said...

From David Beckworth, a conservative economist:

What Successful and Unsuccessful Monetary Policy Look Like
Via Matt Yglesias we learn about the incredible recovery of the Swedish economy and how an aggressive monetary policy played a key role. Specifically, the Swedish central bank expanded its balance to sheet to 25% of GDP versus the Fed's 15%, it set an explicit and clearly communicated inflation target, and charged a negative interest rate on excess reserves. Swedish authorities also were not afraid to see their currency depreciate. All of these steps would horrify the hard-money advocates in the United States, but I would ask to them to consider the benefits the Swedes are now enjoying: lower unemployment, higher real GDP growth, and less overall human suffering.

Just in case there are any lingering doubts about the benefits of more aggressive monetary policy, take a look a the level of nominal spending in both Sweden and the United States. Nominal spending in both countries takes a big hit, but only in Sweden does nominal spending undergone a robust recovery. In fact, nominal spending is about back to its trend level:

So, do we copy Sweden or Japan?

Scott Grannis said...

I would caution about drawing conclusions from Sweden's experience. For one, although the Swedish recovery was stronger than ours, their recession was also much deeper. Both economies have registered similar gains relative to their pre-recession GDP highs. And while it's true that the kroner weakened during the recession/crisis, as did the currencies of most smaller nations, today it is almost as strong as it has ever been against the dollar, and it is almost exactly the same against the euro today as it was in 2007. I don't see any growth or monetary magic there.

However, our unemployment rate is much higher than Sweden's, and I would argue that this has a lot to do with the fact that in Sweden government spending is a much smaller portion of GDP than it is in the US. Sweden never attempted the massive fiscal spending "stimulus" that we tried. That is one lesson that we should learn from Sweden: you can't spend your way to prosperity.

TradingStrategyLetter - Weekly Summary said...

Don't the Swedes have the highest suicide rate in the world? No one wants to copy their model. Lasting strength comes from small governemnt, producing products, and paying your bills. Everything else takes care of itself. The rest is gobblygoop.

Benjamin Cole said...

Dear Trading-

From what Scott is saying, Sweden does have a smaller government than ours, or at least their national government is a smaller fraction of GDP (I don't know if they have states, and how they compare to our states, in terms of spending).

I am in full agreement that the US government should be put on a strict diet, across all military and civilian agencies.

My real point is that Beckworth contends that an aggressive monetary policy worked in Sweden.

While I am dubious about federal spending, I am more open to the idea of an aggressive, pro-growth Fed, in times of deep recession.

I am certain that the course the Bank of Japan has taken--tight money to fight even low rates of inflation--is an abject failure.

Scott Grannis said...

If Sweden pursued a very aggressive (i.e., extremely accommodative) monetary policy, then why is its currency unchanged vis a vis the euro and still very strong vis a vis the dollar? Given the behavior of the kroner I would be tempted to argue (in the absence of better facts) that Sweden's monetary policy was either tighter than the Fed's or at least the same.

Bill said...


Do you think there will be an uptick in the ISM on Friday or do we have another month or two to get over the supply shocks from the quake in Japan?

Scott Grannis said...

I'm only guessing, but I suspect we have seen the worst of the supply chain disruptions. Nevertheless, I doubt that we will see a significant uptick in the ISM on Friday, but even a slight uptick would be enough to reassure markets that the weakness we have seen was only temporary and not the start of a double dip. said...

Are you putting on the TBT and PST trade again, or just staying long equities & commodities?

Scott Grannis said...

I think it makes sense to be short Treasuries for a trade. I'm long TBT.

Benjamin Cole said...


Those are good observations about Sweden's currency. It seems gospel that they they were very aggressive with monetary expansion, yet their currency appreciated for while early in the downturn, through it has been depreciating lately.

They also started charging, not paying, interest on reserves.

septizoniom said...

how do you know what is fear and what is fundamental? is fear not fundamental?. i have puzzled for over 2 years with why you are so resolute in cheerleading, sprinkled with brilliant political analysis and occasional insightful economic analysis. i remain puzzled.

Scott Grannis said...

septi: that's a fair observation. To me "fear" is just that: a reluctance to take on risk that is mostly psychological in origin. "Once burned, twice shy" is a good example. Fundamental factors which reduce people's willingness to take on risk are a very different thing: e.g., very tight monetary policy, impending hikes in tax rates, impending tariff wars, impending new regulatory burdens; in short, impending changes in policies which can reduce after-tax returns because they will profoundly and adversely change the way the economy works. The Greek drama has made people fearful that it might produce unforeseen and terrible consequences, yet no one knows for sure what might happen. To the extent that budget deficits make people fearful because they will inevitably result in cuts in government spending, I think that fear is misplaced because I don't believe that cutbacks in excessive spending are bad for the economy as a whole--they are in fact good.

Frozen in the North said...


My guess, and it is a guess, is that today's ending of POMO is creating all kinds of weird effects in the auction market. Now that the primary dealers can no longer simply put their bonds back to the Treasury. Suddenly investor demand becomes an issue.

Plus the August 2nd deadline is not helping anything here

Scott Grannis said...

Frozen: you may be right, but my money is on the economy picking up. The bond market has had a long time to price in the end of QE2. I've yet to see evidence that QE2 distorted bond prices. The growth outlook is the biggest factor in the bond market, and always has been.