Treasuries: Joy, woe or head fake? James Saft
March 20 (Reuters) – The price of money is going up, but
it’s difficult to know if this signals a return to normality, a
step down inflation’s slippery slope or just a cunning head
Yields on 10-year U.S. Treasuries hit 2.38 percent on
Monday, the latest leg in a move that’s taken the borrowing rate
up by nearly 25 percent in just three weeks.
The yield on 10-year Treasuries is perhaps the world’s most
important financial indicator. Besides representing the cost of
money for the U.S. government, it helps to set the price of
money for all borrowers in dollars, and for many world-wide.
There are, broadly, two leading explanations for the move.
The first, and most-straightforward, is that yields are rising
because investors are seeing something like a sustainable
recovery take hold. Interest rates, on this theory, have been
exceptionally low and are now moving up to reflect a more normal
outlook for growth, and by extension, for inflation.
This argument has the great advantage of being simple, and
is also supported by a generally positive run of U.S. economic
data in recent weeks. Employment and manufacturing are looking
better than they were just months ago and even bank lending is
on a decidedly upward slope.
The market for bonds that pay out based on inflation is
still forecasting price rises of just 2.17 percent annually over
the next five years. That’s a big rise on the 1.63 percent
expected in early January but hardly runaway inflation.
The second thesis is that investors, having bemoaned the
lack of growth for years, are becoming just a little bit spooked
about the inflation that will inevitably accompany it. The
Federal Reserve, Bank of England and European Central Bank are
all being exceptionally loose in historical terms, having
created money and suppressed long-term interest rates through a
variety of rarely used and little-understood measures.
“The three central banks in question all have a clear and
visible inflationary bias” writes Ben Lord of M&G Investments in
London. “They would rather have inflation than deflation
(rightly). But now they are showing a propensity to favor
above-target inflation over below-target inflation. This is
tantamount to a (temporary or permanent, we do not yet know)
change in the inflation targets. And this must, in my opinion,
see higher inflation risk premia.”
Even if the Fed has been successful in engendering a
recovery, it still faces a difficult task in successfully
normalizing monetary policy without losing control of inflation.
The Thomson Reuters/University of Michigan’s survey of one-year
inflation expectations showed a jump on Friday to 4.0 percent
from 3.3 percent last month. This may be a knee-jerk reaction to
higher gasoline prices, but it is a notable jump nonetheless.
FUN HOUSE INVESTING
Indeed, despite the sell-off and the data, New York Federal
Reserve chief William Dudley, a good bellwether for the
Bernanke-led consensus at the central bank, was stressing
caution about the outlook in a speech on Monday. Dudley noted
that dropping labor force participation was partly behind
improving labor data and that business inventory building that
helped growth at the end of 2011 may imply a drag on growth in
early 2012 as those inventories are sold down.
This is the third real possibility: The run-up in yields is
really a head fake, a precursor to a growth bust this year
similar to that of 2011. This view is predicated on belief that
government spending will likely be a drag on growth this year,
as will the consumer’s continued preference for paying back
The truth is that any analysis of the economies past,
present or future is made far more complex by the uncertainty
around monetary policy. That is a huge irony, given the Fed has
taken extreme steps to convince the market it will keep rates
low for a long time.
The uncertainty isn’t just about what the Fed will do,
though it is obvious people no longer firmly believe rates will
stay low until 2014. It is about the widely dispersed range of
outcomes and the deep uncertainties about extending, retaining
or retracting tools like quantitative easing.
Investors, or more broadly people allocating capital, are in
a wilderness of mirrors, one in which things can easily turn out
to be exactly what they seem, or just the opposite.
Yet despite this, equity markets are booming, volatility in
financial markets is at multi-decade lows and even bond markets
are asking for only a tiny amount of extra money in compensation
for all this uncertainty.
Investors seem to be assuming they aren’t in a wilderness,
but on a fun house ride, one controlled by the authorities and
from which they will emerge blinking in the sunlight.
(At the time of publication James Saft did not own any direct
investments in securities mentioned in this article. He may be
an owner indirectly as an investor in a fund. For previous
columns by James SAft, click on