The Treasury Conundrum

The sharp rise in bond yields emerged as an important market force in recent days. US Treasury yields are stabilizing today with note and bond yields near six month highs. The sell-off in US Treasuries in the past two days is the largest in a couple of years. It has caught the market wrong-footed in light of the disappointing jobs data last Friday and the ongoing Fed purchases. It has taken the widening the the 10-year spread to five month highs (just above 200 bp) to keep the dollar at the upper end of its 2 1/2 month trading range.

The sharp rise in US yields is the single biggest factor driving up global yields this week. Indeed, the 2-year US-German interest rate spread, which we find tracks the euro-dollar exchange rate closely has moved in Germany's favor over the last few days and it now near 41 bp is the biggest discount for the US since Nov 26. This suggests the euro may find support around $1.3180.

The US Treasury is finishing this week's $66 bln auction today with a $13 bln 30-year bond sale today. Although the 30-year yield has risen 18 bp, the 10-year yield has risen 26 bp over the past week suggesting the concession may not really be that large to spur demand for a maturity that may be too long for large pools of capital, like reserve managers and sovereign wealth funds. The focus too is shifting toward next week's FOMC meeting. Some observers suggest that the "60-Minutes" interview suggested that the Fed may announce in increase in Treasury purchases. After the FOMC has completed its first tranche of pre-announced purchases, a new announcement is warranted, but this does not mean an increase in the $600 bln figure that when proposed was never cast in stone. Others are saying the Fed may seek to protest (curb) the sharp backing up of US interest rates.

Yet that seems to pay due respect to Bernanke's guidance that in addition to the growth and inflation path, the efficacy of the purchases would be taken into account when evaluating the program. Part of the premise of this round of asset purchases was that fiscal policy levers were off the table. Surprise. Of course, immediate following the electoral results it became more clear that the 2001 and 2003 tax cuts would be extended.

What is new is the 2% payroll savings. Many economists updating their forecasts are revising GDP estimates higher by 0.5-1.0% next year and revising unemployment forecasts a touch lower. However, when calculating the fiscal costs do not seem to be allowing for the greater revenue associated with the stronger growth and slightly less counter-cyclical spending.

Fitch's downgrade of Irish debt to BBB+  means Europe is in a similar position as the US.  In the US, the Fed wanted to keep rates low and the Obama/Republican compromise has pushed rates up.  Fitch's move pushes down the Irish bonds that the ECB has been trying to lift in what continues to appear to be a somewhat more aggressive action. 

Lastly, note that although Japan's real Q3 GDP was revised slightly higher, nominal GDP was revised lower.  This is a testimony to the deflationary grip and raises interesting questions over which is more important.  My sense, for what it is worth, is than nominal growth is how people experience things.