Friday, May 16, 2008

Treasury Yields: A Real-Time Market Sentiment Gauge

Suppose we could conduct a poll each day of traders and investors, asking them for their outlook on the strength vs. weakness of the U.S. economy? That might provide some useful sentiment data.

Well, we have something better than a self-report poll, which may or may not reflect the actual market behavior of these participants. The rise and fall of Treasury yields provides the market's real-time assessment of whether the economy is weakening or strengthening.

If the economy is weakening and requires stimulus, anticipations of Federal Reserve easing will lead to falling short-term yields. If the economy is encountering inflationary pressures and may require monetary tightening, short-term yields will tend to rise.

Like any sentiment gauge, yields can overdo things on the upside and downside. Take a look at the chart above, which tracks two-year Treasury yields versus the cash S&P 500 Index from mid-year 2007 to the present. The correlation between the two is striking. As stocks were falling and housing and credit issues dominated the headlines, yields fell all the way to 1.41%--a negative return vis a vis inflation.

Since March, those concerns have abated to a degree. Stocks have retraced essentially all of their year-to-date losses and yields have moved steadily higher to 2.47%. If traders and investors expect the Fed to put inflation fighting ahead of liquidity provision, we should continue to see rate firmness. That is bullish for stocks, because it means that the Fed is not so worried about bank failures and economic collapse that they need to engage in Japanese-style quantitative easing.

Should we see rates move back toward their March lows, however, it would signify a resumption of worries regarding the financial system and a pricing in of expectations regarding Federal Reserve ease. When new economic data are released, it's worth keeping an eye on short-term yields for a quick poll of market reaction.

If you understand how yields serve as sentiment gauges, then it's not too far a leap to see how the relative movement of yields from country to country reflects real-time pollings of economic strength and weakness on a global basis. This has important implications for currencies, as well as the flows of funds from one global market to others.


It's All One Market