Thursday, December 09, 2010

What bond yields could be indicating...

I have referred often to the belief that the bond market (i.e. interest rates) will be the gun in the back of politicians to force budget cuts.  This week yields have jumped, and the coincidence with the tax cut deal has some uneasy.  Ryan Avent offers some helpful insights.
But yields that rise because the government's solvency is in question are very different from yields that rise because the private sector is competing for the private savings government has lately gobbled up. Which kind of rise in yields are we seeing now?
It's not possible to say with complete certainty, and there may be aspects of both. But I would make one observation on this score. Over the whole of the past week, yields have been generally flat, even as it became clear that a deal on the Bush tax cuts was likely. And most of the budget impact in the deal is attributable to the tax extensions that were expected to pass. But the "new stimulus" in the deal—the payroll tax cut and the accelerated depreciation for businesses—was close to a policy surprise. These measures were actually unanticipated by markets. And so it stands to reason that most of the jump in yields is likely due to their inclusion.
What's important to note is that these aspects account for basically all of the new stimulus in the bill, but they only add modestly to the budget impact of the package. The forecasters revising up their growth expectations probably already had extension of most of the Bush tax cuts in their models, meaning that the upward bump is attributable to the surprise measures. And so it seems reasonable to conclude that most of the rise in Treasury yields is due to improved expectations for the American economy.
Of course, the better the economy looks moving forward, the greater will be the rise in yields. But this is precisely why I've argued that the surest way to get Congress to tackle deficits is to generate a strong recovery. Bond yields will force action, and bond yields respond most strongly to rising growth expectations. [More]
If the economy is stronger than we suspect right now, and with the stimulus effect of the deal, this analysis could prove very timely.

I do not expect interest rates to zoom upward, but we've lost any sense of perspective after years of historically low rates.  Plus the arithmetic of small numbers promises some hyped-up headlines over the first small increases.  For example: raising the prime rate from 3.25 to 4 percent would be shouted as a "23% increase in rates"!  The same rate increase would be seen as less alarming if the prime were 7-8%.

In short, I think we all better have a plan for what we will do if the US economy gets better. 

Hard to get your mind around that, isn't it?

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