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What is the bond market telling us?

Forget all the other noise, all the other indicators that we got this week. Forget all the speeches we heard this week from Fed officials and central bankers and finance ministers talking about how they feel about things.

Let’s just look at how the bond market, and in particular the U.S. Treasury market, feels about things.

The bond market is an incredibly current, incredibly useful way to gauge sentiment about the U.S. economy. When times are good, bond traders worry that inflation is a problem and yields go up (bond prices and yields move inversely). When times are bad, investors flock to treasuries because they are safe place to be. At those moments, interest rate hikes and inflation seem pretty far off, so they are not a factor.

Now let’s think back on the quarter that just ended. A lot of it goes along with the ‘when times are bad’ label.

During the past quarter we learned that the U.S. housing market was double-dipping back down (some people don’t like to use that kind of language, but that’s what is happening, at least if you look at prices). A lot of the U.S. economy looked better—jobs and spending and all that—but companies looked like they were still nervous about investing. Worst of all, the U.S. government sector just started to adjust to much tougher times, with states and local governments cutting back on workers.

And worst, worst of all was the earthquake in Japan, the third largest economy in the world. That hit on March 11th; three weeks later, we still do not have a great idea of how much damage there will be world-wide, but we know it will cut into global growth to some extent.

And sure, the bond market worried about all of that for a bit. In the days following the earthquake and its aftermath, bond yields did fall. Still, after that the market reversed course. The 10 year U.S. treasury ended up at 3.45 percent, up from 3.30 percent at the beginning of the quarter.

So the verdict: growth is the order of the day, and maybe inflation too. Indeed, although house prices may be down and the official indicators may be tame, inflation is starting to creep into some other indicators. Notably, the prices paid component of the U.S. purchasing mangers index is now at its highest level since 2008.

So where do we go from here?

Never mind the past quarter; bond markets around the world have been on a tear really for years. A couple of things may change things in coming quarters, however.

For one, the economic data from the U.S. seems to be getting steadily better. Even the unemployment rate, traditionally the very last thing to show improvement, has dipped 1 percentage point since November.

Second, and way more important, the U.S. Federal Reserve is supposedly getting out of the bond purchase business. The second round of the Fed’s quantitative easing program (QE2) ends in June, and few now believe they will extend the bond purchases. That’s a big negative for the markets.

What does that mean? Well, almost for sure it means that U.S. market interest rates are headed higher. That in turn means that mortgage rates and some lending rates are headed higher too. That might even be the right thing to have happen: if inflation is really an issue, then you want to cool things down.

Thing is, inflation is only one issue, alongside things like ‘growth’ and ‘recovery’ and all that.

Let’s hope that the spike in interest rates is gradual enough to that this fragile U.S. upturn can continue.


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