Sloppy 3 Year Auction Leads to Some Sloppy Thinking
Yesterday's back-up in Treasury yields has been widely attributed to a relatively weak auction where dealers were presumably left holding the bag. That seems to me like an overly simplistic explanation thrown around by salesman grasping for something (anything) to say. Take a look at the chart of 10yr Treasury rates below. First, a more likely explanation is traders doing what traders do; naturally going-with the upside breakout of the Dec/Jan trading range… really, trading 101. Second, the spread of 10yr Treasury yields to 10yr German bund yields remained at 42 bps, even after a very successful bund auction yesterday. So we had a bad auction, they had a great one, and yet the spread stays the same. It's obvious that something more is going on here.
It seems that last summer's double-dip freakout has been replaced by a growing inflation scare. Yesterday also saw a number of Fed-speakers fanning the flames of that fear by expressing concerns about QE2 and its inflationary impact. But much as the market got ahead of itself in expecting a double-dip recession, so too do I think that fears of inflation are getting overblown. The Fed funds futures market is now expecting the first tightening by the Fed to occur at the Dec. 2011 meeting. I continue to think it won't happen until well into 2012. True, the FOMC has stated it would like to see core inflation move higher, and the highly volatile food and energy components of headline inflation are far outpacing the core inflation on a relative basis. But looking again at the chart below, fully 70% of the 140+ bp move up in 10yr Treasury yields since the early October lows has been in real yields, with only 30% due to rising inflation expectations. I believe inflation expectations are simply normalizing after the double-dip deflation scare.
Looking back over the last three-plus years, there have been a number of times where 10yr Treasury yields have taken a run at the 4.0%ish levels. The highest peaks were reached in Dec. '07 and June of '08 at 4.30%, and the lowest were Aug. and Dec. '09 at 3.85%, with the average being around 4.05%. As I described in our recent Market Commentary, I suspect it will be very difficult for yields to penetrate the multiple levels of resistance in the near-term, and may offer opportunity for those who are more tactically inclined.