Senin, 10 September 2012

Bond market despair

This chart shows the yield on 2-yr Treasuries, currently 0.25%. It's about as low as it's ever been, and that means that the bond market holds out very little hope for any meaningful growth in the U.S. economy for the next several years. To understand why that is the case, consider simply that the 2-yr Treasury yield is equivalent to the market's expectation for what the Federal funds rate—currently 0.16%—will average over the next two years. Market arbitrage ensures that this is so, because investors on average must be indifferent to holding cash at an overnight rate for the next two years (earning whatever the Fed funds rate adds up to), or investing in a 2-yr Treasury note and locking in the current rate for the next two years.

Expectations are running high that the Fed will engage in another round of quantitative easing given the weak growth in jobs and the generally weak nature of the U.S. economy. But even strong expectations of QE3 have failed to increase the market's confidence in the future. What they have done, however, is to increase future inflation expectations, as seen in the chart below:

The 5-yr, 5-yr forward implied inflation expectation embedded in TIPS and Treasury prices has reached 2.8%, up from 2.0% about one year ago.

In other words, the bond market believes the economy will remain very weak despite more quantitative easing, and that inflation will tend to rise nonetheless.  The bond market vigilantes are saying that more Fed ease won't help the economy, but it could hurt via higher inflation. The gold market agrees, having sent gold prices up 8% in the past few weeks. All of this should give the Fed pause. We already have $1.5 trillion of excess reserves; adding more won't make the economy stronger.

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