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The bond market is getting restless




This chart shows 10-yr Treasury yields since the beginning of last year. Note that yields reached a high of 4.0% in early April, right before several bearish announcements (the Gulf oil spill and the downgrade of Greek debt) triggered a wave of concerns that eventually gave us the economic "soft patch" which lasted through late summer. An economic slowdown, coupled with a lot of hand-wringing over the prospects of a Eurozone financial crisis, pulled yields down to a dismal 2.4%. Then we had talk of QE2 reviving the economy, then we had rising inflation expectations as a result of QE2, then we had a string of economic releases (e.g., falling unemployment claims, strong exports, strong capex, strong car sales, strong corporate profits) that gave credence to the idea that the economy was actually accelerating. 10-yr yields appeared to have been capped at around 3.5%, however, with the support of continued QE2 purchases from the Fed and the market's belief that the economy's upside growth potential was limited.

That latter notion is what is being challenged in the past several days. 5- and 10-yr Treasury yields are breaking out to new high ground as the market begins to realize that the economy is growing, not struggling, that commodity prices continue to rise unabated, bank loans are accelerating, money supply measures are registering 6% and more, and the Fed may be overstaying its welcome with QE2. Besides, who wants to own Treasuries that pay 3.6% or less when nominal GDP growth—the rate at which corporate profits tend to rise over time—could be 5-6% or more? Bottom line: Treasury yields need to be more in line with expected nominal GDP growth, and QE2 purchases can't change that reality. Rising yields are an excellent sign, therefore, that the economy is picking up.

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