Wednesday, June 15, 2011

Treasurys Retreat: Are the Bond Vigilantes Back?

The Obama tax deal with the Congressional Republicans has led to mostly cheer on Wall Street. Economists are revising growth estimates for 2011 upwards by as much as 1% due to the tax cuts and stocks have generally had a stronger tone.

But for all the Christmas good cheer, there’s a bit of Grinchiness sneaking into the equation. The Treasury market has sold off hard this week as the fiscally prudent bond vigilantes seem to have awoken from slumber. The big tax cut bonanza has sent a simple message, according to Deutsche Bank’s Alan Ruskin: “Forget fiscal consolidation for at least two years, and just possibly even worse – forget Uncle Sam biting the bullet before the bullet bites you.”

In addition, the U.S. approach to its economy – expansive fiscal policy (tax cuts, tax cuts, tax cuts) and expansive monetary policy (QE2!) – is diametrically opposed to the European approach to its own economic woes (austerity). Most economists on the Street seem to favor the U.S. approach, and not just because their taxes aren’t going higher.

The sharp downturn in Treasurys, however, could change the equation. Yields on the 10-year bond, which move in the opposite direction of price, have risen to 3.19% from below 3% just last week, a huge move. The move in the bond market is all the more perplexing because the Fed is supposedly buying lots of Treasurys. As the Fed itself has said, rapidly rising long-term rates is the last thing the fragile recovery needs right now. It will be interesting to see if Big Ben Bernanke can put the bond vigilantes back to sleep.

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