The Treasury Yield Non-Conundrum

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SocGen economist Aneta Markowska affects bemusement at the benign bond yield environment in the US. As she put it in a recent note (any emphasis/links FT Alphaville’s):

Sovereign debt concerns have rocked many economies in recent months. Fundamentally, countries with large twin deficits are most vulnerable because they have to rely heavily on foreign investors to finance their government budget gaps. Based on these criteria, the US is right up there with the most vulnerable economies. So why are Treasury yields trading below 3.6 per cent?

And as economists are wont to do, Markowska provides three major reasons as a potential explanation for the phenomenon:

1 – Inflation trends remain very low. Core CPI was flat in Q1 and the y/y trend now looks set to dip below 1%

2 – Fed has been very slow to embrace the cyclical recovery and shift to a more neutral policy stance. The “extended” language is a green light for bond investors to remain in carry trades.

3 – Treasuries and the dollar have benefited from safe haven flows.

Of course, this being a SocGen note, there’s a caveat: Markowska believes those three factors “are very transitory and the risks for bond yields are skewed largely to the upside.”

For the moment, however, SocGen contends that “Treasuries are trading in line with fundamentals”:

But there may be a real conondrum elsewhere, in “the fact that the unsustainable fiscal outlook is not triggering higher risk premiums”:

So far, neither investors not forecasters are showing any serious concern about the unsustainable fiscal path. One explanation is that markets implicitly assume the necessary reforms will take place before it is too late. Of course, by betting heavily on Congress to do the right thing, investors may be setting themselves up for a disappointment. But, that disappointment may still be a few years away.

And therein lies the major difference between the peripheral European countries and the US — the US simply has more time to address its fiscal problems, according to the SocGen economist:

This additional time is partly an outcome of greater credibility of US policy, but even more importantly it is a function of US growth dynamics. The latter is a key differentiating factor between the US and peripheral Europe.

…

The US is achieving some degree of fiscal consolidation via growth, rather than via painful austerity as is the case in the European periphery. While cyclical forces are likely to push bond yields higher, they will be going up for the “right reasons”, and at a pace that is unlikely to derail the recovery.

Related links: US debt saturation *alert* – FT Alphaville Europe is Lehman-fied, part quatre – FT Alphaville In Europa We Trust – FT Alphaville The deflationary pain in Spain – FT Alphaville

This entry was posted by Stacy-Marie Ishmael on Friday, May 14th, 2010 at 21:31 and is filed under Capital markets. Tagged with bond yields, europe, inflation, Sovereign debt, Treasuries, us, usa. Edit this entry.

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