Bond Yields

In the wake of the Fed’s meeting and press release yesterday, it’s time to check in with the bond market. The Fed’s announcement apparently came as no major surprise to the bond market, for yields changed very little. But over the past six weeks we’ve seen quite a major increase in long-term interest rates:

(Note: yield expressed in tenths of a percentage point, so 45 = 4.5%)

Interestingly, the increase in yields recently primarily reflects an increase in inflation expectations, not an increase in real interest rates. One can see this by comparing the yields on inflation adjusted bonds and regular, non-inflation adjusted bonds.

Expectations of inflation have increased steadily over the past 18 months, but the real (i.e. inflation adjusted) interest rate has not risen at all — in fact, it’s actually fallen a bit. What does this mean? One possible explanation is that the bond market doesn’t expect the demand for borrowing in the economy to increase much from current levels. Given that the bond market has learned a lot about the future course of government borrowing during the past 18 months, the fact that they expect overall borrowing in the US to remain roughly constant may imply an expectation that private sector borrowing will not increase much. Could this be a sign that the bond market isn’t expecting much of an economic boom over the next few years?

Kash