Saturday, June 13, 2009

Economic Speculations

The charts above compare two-year (top chart) and thirty year Treasury rates (bottom chart) since 2007. Note how rates bottomed out ahead of the early March stock market low. Thirty-year rates have rebounded particularly strongly, as fears of deflation have given way to a reflation theme. Most recently, we've seen a spike in two-year rates, as concerns about the weak dollar and inflation have led to speculation regarding Fed tightening.

These rates--and the yield curve relationship between them--provide a nice window on the sentiment of the market, as we handicap the odds of inflation and/or Fed tightening impacting the economic recovery. Higher long term rates mean higher mortgage rates, which become a potential obstacle to recovery in housing. Further purchase of Treasuries via quantitative easing, however, raises the specter of keeping rates low at the cost of further economic debt.

How we navigate the threats of inflation/deflation will play a major role in determining Treasury rates, the U.S. dollar, and stocks in coming months. As I talk with traders, the consensus appears to be that we have gone overboard loosening the monetary spigots, making inflation inevitable, and driving the U.S. dollar lower, while driving gold and other commodities higher.

I'm wary of consensus views; in this case I suspect they underestimate the embedded weakness within the economy, as the usual consumer-based credit-drivers of economic recovery are no longer in a position to kick start growth. When China, which *has* been flooding its economy with liquidity, faces the twin threats of inflation and bad loans, the resulting contraction will provide ample opportunity for us to experience a double dip in the economy, pressuring stocks and commodities, lifting the U.S. dollar, and easing pressure on interest rates.

At that point, we would face massive deficits *and* significant economic weakness: a situation that just could lead to the kind of fiscal irresponsibility that would yield a period of inflation and significant dollar weakness. While the recent bounce in stocks and credit markets has been welcome, it's far from clear that the worst is over: in fighting off deflation, we may have created new, different, and intractable problems that would take years to address.