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.

Is the bounce contagious?

So many things collapsed in price from last September through the end of the year, only to bounce this year: shipping costs, most commodity prices, corporate debt prices, and emerging market stocks and bonds. It's enough to make you think that it isn't just a coincidence; that global economies hit an airpocket last September but have since begun to recover. Equity markets haven't bounced yet, but virtually all equity markets around the world have stabilized over the past several months, and many are up from their lows.

It's therefore quite tempting to wonder whether the recent and ongoing bounce in commodity prices, shipping costs, and corporate bond prices will be replicated in the equity markets. I think it will. I think the improvement in shipping costs, commodity prices and credit spreads reflects an improvement in the underlying economic fundamentals. The U.S. and global economies are not in free-fall, they are in the early stages of recovering from what was a sudden and massive loss of confidence in the global banking system that paralyzed commerce.

Whatever solutions Geithner gives us tomorrow, and whatever the fate of the faux-stimulus bill in Congress this week, if equity markets improve, it will not be solely due to the helping hand of government, it will be due also to the market's ability to recover from its own excesses.

Agency spreads on the mend (2)

Since I last showed this chart, a week ago, FNMA spreads to Treasuries have improved by 10-20 bps. That's a sign that the market is increasingly confident that the U.S. government will stand behind its implied promise to guarantee the debt of Fannie and Freddie. This whole crisis began with widespread distrust of any and all counterparty risk, so it's very important that we see this kind of progress because it means the market is healing its wounds. There is still much progress to be made in other areas of the bond market, of course, notably with corporate and emerging market debt spreads. While credit spreads haven't narrowed of late, the remain significantly below the highs of a few months ago.