Markets & Finance

Vital Signs: Don't Fear the Rise in Treasury Yields


On deck: homebuilders survey, housing starts, industrial production, producer and consumer prices, current account deficit, Philadelphia Fed index, leading indicators

The recent surge in the yield on the benchmark 10-year Treasury note has set off alarm bells for investors. On June 11, yields touched 4% briefly, up from 2.5% on Mar. 18. Oddly enough, that was the day the Federal Reserve announced it would begin buying Treasury securities in an effort to push down longer-term rates generally and mortgage rates in particular. Clearly, the strategy hasn’t worked. Over the same period, 30-year fixed mortgage rates have climed from 4.75% to more than 5.50%.

Some investors fear higher rates will kill off prospects for an economic recovery. However, it may well be just the opposite: Treasury yields may be rising because prospects for a recovery are looking better.

Traders offer several explanations for why yields are rising. They cite worries about inflation, reflecting concerns that the Fed will not be able to absorb the massive amount of monetary stimulus they have pumped into the system fast enough to prevent it from stoking inflation. They also fret about the enormous supply of Treasury debt hitting the markets, as Washington funds its budget deficits.

Right now, though, the explanation that makes the most sense to economists is fears of a financial Armageddon are passing, and signs that the recession is bottoming are growing. As a result, investors are regaining some of their appetite for risk. For example, while 10-year Treasury yields have risen 1.5 percentage points, yields on Moody’s Baa-rated corporate bonds have fallen 0.6 points, from 8.3% to 7.7%. The spread between the two, a measure of the risk premium investors place on lending money to these corporate borrowers, has declined significantly in recent weeks. Basically, investors are showing an increased preference for corporate debt and less demand for the relative safety of Treasury debt. Amid reduced demand for Treasuries, the onslaught of supply from Washington is only adding to the downward pressure on prices and, therefore the upward pressure on yields.

Of all the possible explanations for the recent surge Treasuries, fears of inflation are easily the most unlikely, especially with so much slack in the economy and propects that this slack will not be absorbed by faster economic growth any time soon. When this recession ends, most likely in the second half of this year, real gross domestic product will be about 8% below where it would be if all currently available workers and production capacity were fully utilized. Until that slack is used up, economists know that inflation cannot take root. Even growing at 4.5% per year starting right now, it would take until the end of 2011 to use up all the economy’s excess resources. That means the Fed will have plenty of time to mop up its flood of liquidity before inflation becomes an issue.

For now, the rise in Treasury yields may actually be part of the normal recovery process. If so, the rise should be embraced, not feared.

Here’s the weekly economic calendar, from Action Economics:

Top Economic Reports

Reports

Date

Time

For

Median Estimate

Last Period

Empire State Index

Monday, June 15

8:30 a.m.

June

-3.0

-4.6

Producer Price Index

Tuesday, June 16

8:30 a.m.

May

0.5%

0.3%

Producer Price Index (excluding food & energy)

Tuesday, June 16

8:30 a.m.

May

0.1%

0.1%

Housing Starts (millions)

Tuesday, June 16

8:30 a.m.

May

0.500

0.458

Industrial Production

Tuesday, June 16

9:15 a.m.

May

-0.6%

-0.6%

Capacity Utilization

Tuesday, June 16

9:15 a.m.

May

68.6%

69.1%

Consumer Price Index

Wednesday, June 17

8:30 a.m.

May

0.3%

0.0%

Consumer Price Index (excluding food & energy)

Wednesday, June 17

8:30 a.m.

May

0.2%

0.3%

Current Account ($billions)

Wednesday, June 17

8:30 a.m.

Q1

-$85.0

-$132.8

Philadelphia Fed Index

Thursday, June 18

10:00 a.m.

June

-18.0

-22.6

Leading Indicators Index

Thursday, June 18

10:00 a.m.

May

0.6%

1.0%

Other Reports and Events

Report/ Event

Date

Time

For

Treasury International Capital

Monday, June 15

9:00 a.m.

April

Chicago Fed President Evans

Monday, June 15

9:30 a.m.

NAHB Homebuilders Survey

Monday, June 15

1:00 p.m.

June

ICSC-UBS Store Sales

Tuesday, June 16

7:45 a.m.

June 7-13

Johnson Redbook Weekly Store Sales

Tuesday, June 16

8:55 a.m.

June 7-13

Mortgage Applications

Wednesday, June 17

7:00 a.m.

June 7-13

Initial Unemployment Claims

Thursday, June 18

8:30 a.m.

June 7-13


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