This isn’t the first time, and I doubt the last, that I have used a post by Scott Sumner as the basis for one of my own. But a blogger’s gotta do what a blogger’s gotta do. Scott is properly worried by the falling yield on the 5-year Treasury. The entire yield-curve is shifting down rapidly. The yield on the 10-year constant maturity Treasury, which I follow closely, because I use it in my empirical model correlating movements in the S&P 500 with inflation expectations, has fallen to 2.68%, 30 basis points less than it was last Thursday and 54 basis points less than it was on July 1. In the meantime the S&P 500 at this moment is down about 40 points since Thursday and 70 points since July 1.
The sharp decline in Treasuries seems to have been triggered by the downward revision real GDP released by BEA on Friday. As a result, the decline in Treasuries was reflected almost entirely in a decline in the inflation adjusted yield of TIPS-bonds. Today, however, if I am reading Bloomberg’s quotations correctly, the yields on conventional Treasuries are dropping faster than the yields on TIPS bonds, as they did yesterday, suggesting that inflation expectations are also declining, perhaps explaining why the stock market decline is accelerating today. Remember the stock market loves inflation.
All of this is starting to get really scary. The markets obviously believe that the real economy is deteriorating. They presumably interpret the recent budget deal as a sign of increasing fiscal tightness, but the news story quoted by Scott suggests that the Fed is not at all inclined to provide any new monetary stimulus to compensate for the loss of federal spending. The dollar is appreciating against the Euro, providing further evidence that inflation expectations are falling.
I really don’t like what I am seeing out there. HELP!