Even before the Fed acts, the long bond is signalling rising inflation worries

11/01/2010 8:30 am EST

Focus: STOCKS

Jim Jubak

Founder and Editor, JubakPicks.com

Something odd is happening in the bond market on the way to the Federal Reserve’s second program of quantitative easing: Interest rates at the long end of the Treasury market have started to rise.

From one perspective this is counter-intuitive. The Fed is about to unleash a campaign of bond buying on the Treasury market that is designed to drive up bond prices and drive down yields. The hope is that this will give more oomph to a flagging U.S. economy. In anticipation bond prices should be going up and yields down. 

But from another perspective this absolutely makes sense. The Federal Reserve has direct control over short rates through its decisions on what to charge banks to borrow, short-term, from the Fed. The central bank’s program of quantitative easing is targeted at medium-term Treasuries, those bonds with five to seven year maturities in an effort to drive down interest rates in that part of the bond market.

That leaves the long-end of the market—Treasuries with ten, 20, and 30 year maturities—relatively untouched by the Fed’s program and free to respond to market forces. And that means free to respond to fears of future inflation. If they’re buying bonds with a 20 or 30-year maturity, investors think they’re just about certain to see higher inflation over that time frame and so they’re asking for higher yields to compensate for that inflation risk. 

At the longest end of the Treasury market, the yield on the 30-year Treasury has moved back above 4% with the bond closing at 4.05% on October 27. (It fell back to 3.98% on October 28.) The 30-year bond yield hasn’t been above 4% since early August and the highest yield then was just 4.05%. You have to go back to June 2010 to find a 30-year yield above 4.1%.

 The rise in yields at the long end of the Treasury market is one reason for the stock market’s sluggish performance in the last week. Rising yields bring more investors, especially overseas investors, into the Treasury market. That resulting dollar buying pushes up the price of the U.S. dollar. A rising dollar, in turn, leads to weakness in commodities and commodity stocks.

The major result of a strengthening dollar has been the weakening of the euro. The euro has been falling rather conspicuously in the last week, just when the dollar has been climbing.

Of course, events in Europe haven’t exactly helped the euro. Nothing like the prospect of a shutdown of the French economy and the cliffhanger agreement on the Portuguese budget to bring out the old euro worries.

Related Articles on STOCKS