What a month makes in the bond market

Last month we were s till in a slightly inverted yield curve environment. This has been a good indicator of a slowdown in economic activity and has always preceded a recession. Not this time. In a about a month, we have moved from the inverted environment to an upward sloping bond market with a significant increase in long-term yields. Short-term yields, as measured by the Fed funds rate, have been fixed at 5.25 percent for just under a year. The revision of the long-end of the yield curve is related to three factors which will have to be watched closely to determine whether the change in yields will be sustained.

Growth prospects have increased in the US. The housing market problem, albeit not going away, has not carried over to other sectors to such an extent that growth has had a further slowdown in the first half of 2007. The key housing season is the summer. If the market falters with higher mortgage rates during this key period, real yields will have to adjust downward.

The inflation rate has stayed above the Fed target. The chance that the Fed will lower rates to help economic growth seems significantly diminished. The expectations concerning inflation have also changed. Instead of focusing on core inflation, there is a growing interest in overall inflation including food and energy. The cost of gasoline and food is viewed as an area that cannot be ignored when calculating inflation values. People have to eat and drive their cars. There will be more focus on the composition of inflation over the next few months.

The international picture is a concern. With central banks showing less interest in holding US dollars, there has to be a another group that will buy US Treasuries, if they cannot be found at the current yields, the market will have to provide an added premium to provide a reason for private investors to hold treasuries. This will cause the long-end yield to increase. Keep an eye out for who is buying Treasuries to get an idea of the direction of risk premiums.

The size of the Treasury change seems greater than what would be expected given the actual economic numbers. This does not means that yield will show a significant decline in the next couple of weeks; however, any upward trend will be slowed if we do not have more bad news surprises in bond land.