Monday, March 19, 2012

US Treasury Bond Yields

The backup in the 10-year US Treasury bond yield since late February certainly reflects mounting confidence in the strength and sustainability of economic growth. The nominal yield rose to 2.31% on Friday despite the Fed’s commitment to continue its Maturity Extension Program (MEP), a.k.a. “Operation Twist.” Since MEP was introduced on September 21, 2011, the bond yield has traded mostly below 2.0%. Perversely, yields might be starting to untwist because inflationary expectations are rising. The spread between the 10-year nominal and TIPS yields shows that expected inflation has jumped from 1.86% when MEP was introduced to 2.4% on March 16.

Contributing to the backup in bond yields were better-than-expected February reports for employment on March 9 and retail sales on March 13. In addition, the statement released by the FOMC after the meeting on March 13 noted: “The Committee expects moderate economic growth over coming quarters and consequently anticipates that the unemployment rate will decline gradually toward levels that the Committee judges to be consistent with its dual mandate.” There was no hint of any new rounds of quantitative easing or yield curve twisting.

In the February 7 Morning Briefing, I raised the following warning flag: “What if the economic indicators continue to be stronger than expected? What if employment gains are even stronger in coming months than they were in January and the unemployment rate falls below 8%? The consensus interest rate outlook/forecast/assumption (or whatever it is) of the members of the FOMC implied that they expect that the economy will remain weak through the end of 2014. That’s a very gutsy forecast for the next three years, and already seems like it could be ridiculously wrong. If so, will the members of the FOMC raise their interest rate projection during their next quarterly survey? If they do, there is a good chance that bond yields will soar on that news. If they don’t do so, their credibility and objectivity will be seriously compromised.”

A backup in bond yields could be quite a jolt for retail investors. Last year, their net inflows including reinvested dividends into bond mutual funds totaled $214.0 billion, while there was a net outflow of $67.5 billion from equity mutual funds. Inflows into bond funds remained strong through last week. Corporations have issued roughly $400 billion in bonds since the beginning of the year.

On March 8, I wrote: “In my opinion, the Fed should let Operation Twist terminate as scheduled and cease and desist from any additional easing. More likely is that Operation Twist will be extended through the second half of the year if bond yields start moving higher. The Fed’s excuse for doing so is likely to be that the housing recovery remains fragile, so it is important to keep mortgage rates low.” There is already some chatter about the FOMC implementing a program of sterilized bond purchases at either the April 24-25 or June 19-20 meeting of the committee. Extending MEP may not make sense since the Fed is projected to have only $200 billion of short-term Treasuries by mid-year. (More for subscribers.)

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