One of the themes that the market-is-inefficient crowd likes to point to as a smoking gun is the volatility in the stock market, which at times ramps up considerably. Robert Shiller was the first to use this argument in his widely cited 1981 paper: “Do Stock Prices Move Too Much to be Justified by Subsequent Changes in Dividends?” There’s been a lot of back and forth over this paper in the decades since, but that’s a subject for another day. Meantime, if the volatility in stock prices indicates inefficiency and irrationality in the equity market, the same framework must hold for bonds, right? Enter Paul Krugman, who had an interesting blog post yesterday about fixed income: “What’s moving interest rates?”

Krugman points to a chart showing the wide fluctuation in the 10-year Treasury Note yield in recent years:

Keep in mind that Krugman is no fan of the efficient market hypothesis. As to the chart above, Krugman notes:

The red line is the 10-year rate, the blue line the level of new claims for unemployment insurance, a leading indicator for changes in the labor market. [Unemployment insurance] claims are a pretty crude indicator of expected economic performance; even so, you can see that 10-year rates plunged in the worst of the slump, when people thought we might actually be seeing a second great depression; they rose as people started to think, well, maybe not; they fell through much of 2010, as the recovery lost steam; and they’ve picked up somewhat recently, as the data flow has looked somewhat better.

Sounds like a fairly reasonable view of how investors might evaluate the state of fluctuating bond rates. Economic conditions change, which moves interest rates, and in turn that influences investment decisions. The market responds to macroeconomic data as it arrives. Expected return and risk fluctuate, in other words, and so investors adapt to the fluctuations. Is that irrational? Or maybe it’s a rational response to a irrational market behavior. But can one side be rational and the other crazy? Hmmm…