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How much longer will the Fed worry about the economy?

February retail sales were much stronger than expected, and as this chart shows, they have been rising strongly for the past three years. Over the past year, sales are up 6.5% in nominal terms, and about 4% in real terms. I think this is strong evidence that the economy is no longer fragile and in need of super-accommodative monetary policy. But when will the Fed finally wake up to this reality? It could be sooner than most folks think.

2-yr Treasury yields (shown in the chart above) are effectively the market's best guess for what the Fed funds rate is going to average over the next two years. From the lows of last September, when the world thought that the Eurozone sovereign debt crisis was sure to plunge the global economy into another deep recession, 2-yr Treasury yields are up almost 20 bps. That equates to almost two Fed tightenings over the next 2 years; not all that much, but this is evidence that the bond market is beginning to realize that the funds rate is not going to be pegged at 0.25% for the next 2 years as the Fed has been promising.

The long end of the Treasury curve is also beginning to have doubts about just how much more the Fed needs to do to pump up the economy. 30-yr yields are up about 50 bps from their all-time lows of early last October. If the market became convinced that the economy was in a sustainable expansion, yields would be much higher still—at least 4%. If anything is fragile it's not the economy, it's the health of the Treasury market, which is still trading at very low yields that only make sense if the economy is at real risk. 

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