Looking at the yield curve may tell us that the bond market sell-off has gone too far. Taking mid-August as the starting point. The long-bond has increased by 85 bps from 3.71 to 4.57. The spread versus three-month bills is 440 bps. Even the 2-year - 30-year yields have a differential of over 400 bps. Fed policy is keeping the short-rates artificially low so the yield spread may not have the same information value, but the numbers are very wide.
Looking at the simple 2% inflation rule suggests that long-term growth will be about 2% with some room for a risk premium. By this measure the current yields seem to be reasonable. If growth or inflation come in higher, there is actually room for this spread to get wider and for long rates to increase even more. Any flattening may come from the front-end moving higher. If you are in the high growth camp with controlled inflation, there is more bad news ahead for the bond market.
The new paradigm of slower growth and the potential for soft price increases suggests that a rally is ahead. Inflation coming in below 25 with soft growth will mean lower yields.
This is the bond world of two extremes and is one reason for the high volatility. Any change in the marginal investors to one camp or the other will lead to a wild bond price swing.
The tie breaker is the pull of fiscal supply. If the economy does better, here will be a increase in demand for private funding. Pressure will build in the interest rate markets if there is not a decline in government spending. On the other hand, if growth is slow, there will be continued high budget deficits which will provide a headwind from allowing rates to move lower. In all cases, a loanable funds story suggests rates are going higher. Certainly higher growth will mean a decline in savings which again will place pressure on rates.
Though the battle of the two extremes will continue, we still argue that there will be longer-term bias toward higher rates.
Looking at the simple 2% inflation rule suggests that long-term growth will be about 2% with some room for a risk premium. By this measure the current yields seem to be reasonable. If growth or inflation come in higher, there is actually room for this spread to get wider and for long rates to increase even more. Any flattening may come from the front-end moving higher. If you are in the high growth camp with controlled inflation, there is more bad news ahead for the bond market.
The new paradigm of slower growth and the potential for soft price increases suggests that a rally is ahead. Inflation coming in below 25 with soft growth will mean lower yields.
This is the bond world of two extremes and is one reason for the high volatility. Any change in the marginal investors to one camp or the other will lead to a wild bond price swing.
The tie breaker is the pull of fiscal supply. If the economy does better, here will be a increase in demand for private funding. Pressure will build in the interest rate markets if there is not a decline in government spending. On the other hand, if growth is slow, there will be continued high budget deficits which will provide a headwind from allowing rates to move lower. In all cases, a loanable funds story suggests rates are going higher. Certainly higher growth will mean a decline in savings which again will place pressure on rates.
Though the battle of the two extremes will continue, we still argue that there will be longer-term bias toward higher rates.
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