In his “60 Minutes” TV interview on Sunday, Federal Reserve chairman Ben Bernanke reminded the world that the central bank can raise interest rates in 15 minutes. The bond market is similarly endowed with the power to move the prices, and therefore yields, of fixed-income instruments in more than gradual increments, as this week’s trading reminds.
The benchmark 10-year Treasury Note’s yield rose to 3.15% yesterday—the highest since June. The market’s forecast for inflation is also rising. Yesterday’s implied prediction for inflation rose to a 7-month high of 2.23%, based on the yield spread between the nominal and inflation-indexed 10-year Treasuries.
In looking for reasons why interest rates and inflation forecasts are moving higher this week, the list of possibilities starts with the news that the Bush tax cuts will be extended. The New York Times labels the tax deal a “back-door stimulus plan.” The bond market apparently agrees.
Indeed, some critics worry about the cost of the tax cut deal. The price tag could be as high as $1 trillion, according to Moody’s Analytics via USA Today. There’s hope that the the tax cut proposal will bring higher economic growth, but there’s also concern about what that will mean for inflation. As USA Today advises:
Bond traders worried that the Treasury would have to increase its borrowing to finance the government’s operations — and that the extra borrowing could lead to added inflation in the future. The yield on the benchmark 10-year Treasury note, for example, soared to 3.13% Tuesday — from 2.93% Monday— its highest level since June…
If the inflation rate moves beyond the Federal Reserve’s target of about 2%, the Fed could be prompted to raise interest rates sooner rather than later to keep inflation in check, says Anthony Valeri, fixed-income investment strategist for LPL Financial. “Short-term futures are showing a slight possibility of a rate hike in November of next year,” Valeri says. He thinks that’s unlikely, however, given the economy’s weakness.
Meanwhile, Barron’s reports:
Economists reckon the tax package will add one-half to a full percentage point to real growth in 2011, with estimates now falling in the 3%-4% range. The better growth prospects from the fiscal proposals reduce the chances the Federal Reserve will purchase more than the $600 billion in Treasuries it currently plans; indeed, the central bank could buy less if the economy picks up.
None of this is surprising in the wake of big changes for the macro environment. Expected returns and risk fluctuate, and sometimes they fluctuate more than usual when the catalysts are supersized. “The tax cuts have changed the market’s landscape,” Arihiro Nagata, fixed income manager at Sumitomo Mitsui Banking, tells Reuters. “A lot of people are now changing their scenarios. Many economists are saying the tax cuts will push up U.S. growth by 0.5 to 1.0 percentage point.”