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The Treasury Correction
Higher bond yields are a signal of growth.


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David Malpass

This week, Treasury-bond yields rose to their highest level since August 2002. The yield on the 10-year Treasury (as of 7/29) rose to 4.4 percent from the 3.1 percent low on June 13. We are now six weeks into the Treasury-market correction.

But rather than putting a drag on the economy — and contrary to a popular opinion in the media — the increase in Treasury yields is an integral part of a constructive multi-year reflation. It has erased the May-June deflation buzz and should increase the chances that businesses will invest and buy inventory.

Moreover, at some point soon, the weight of evidence from the value of the dollar and other market-based indicators will allow closure of the 1997-2002 strong-dollar deflation episode, restarting investment outside the U.S. as domestic growth accelerates. Interest-rate increases, like bond-yield increases, are an integral part of the reflation process. And the sooner the Federal Reserve can move overnight rates back toward normal levels in the context of a stable dollar, the better for the long-term growth outlook. In the meantime, the uncertainty over the timing and size of Fed rate increases weighs on the outlook. The current 1 percent federal funds interest rate causes an increasing bias in the economy toward interest-rate dependent investments in lieu of long-term profitability. There are still some concerns about this economy — consumer confidence fell in June and mortgage rates are set to increase substantially. As for the first concern, the consumer-confidence index is not typically used as a leading indicator of the economy or consumption. Business confidence, business investment, and inventory rebuilding are the key variables in the strength of the reflation. As for mortgage rates, Americans can expect price weakness in some local housing markets as well as some cooling of residential investment. But there shouldn’t be a nationwide house-price problem or a slowdown in consumption growth as mortgage refinancing slows. The decline in interest rates and bond yields in recent years has provided a windfall for homeowners, as did the 1997 capital-gains tax cut. With the economy accelerating, the weakness in housing should be limited. Now for the positive developments — and there are a few of them. One indicator of monetary policy stimulus is the Treasury yield curve, and it has steepened to a record. The 10-year bond yield is 2.75 percent higher than the 2-year bond yield ( which was 2.6 percent in 1992, the previous record) and 2.5 times greater (it was only 1.6 times in 1992, the previous record). This “steepness” of the yield curve reflects the unusual nature of reflation and the preceding deflation. In addition, the spreads on corporate bonds and emerging-markets bonds have narrowed further as Treasury yields rose, a indication of confidence in the growth outlook. As for the stock market, U.S. equities have held their levels over the last month in the face of the higher Treasury-bond yields and interest-rate expectations. And gold and commodity prices have risen further, signaling reflation and growth. On a trade-weighted basis, foreign currencies have weakened against the dollar in recent days, which is evidence of the continued attractiveness of the U.S. investment climate despite recent losses in Treasury bonds. As U.S. growth accelerates, there should be some continuation in this currency trend. From most angles, the Treasury-market correction is confirming that this economy is reflating, and that accelerated growth is on the way.


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