This past week has seen dramatic moves in the global gold prices and the yields on debt issued by the United States Treasury. Since February 28, the gold bullion prices have fallen substantially. Of the 14 per cent drop from the highs last year, eight per cent of the decline has come since the end of February 28. In the US Treasury markets, the yields have been spiking by the hour.

Any average investor, who sought to refinance their house to a lower rate, during the past week, found that the mortgage companies and banks were remarkably reluctant (in not so many words) to accommodate the borrower at lower rates.

During trading on Monday, compared to levels on Friday, the 30-year bond yield was up by 0.07 per cent and presently trades around 3.48 per cent. The ten-year bond traded was similarly up by 0.08 per cent compared to Friday at around 2.38 per cent. (Do remember, bond yields rise when bond prices fall). Concurrently, the US equity markets have risen over to highs not seen in the past four years.

The Standard and Poor's Index is up to 1,409, which is almost a five-year high. The highest was at 1,565 in October 2007. In fact, compared to the lows of March 2009, the S&P has returned more than 100 per cent.

Some possible inferences are in order: (i) an increasing number of market participants seem to believe that an economic turnaround is in the offing, or already here and/or (ii) given the still relatively weak economic data, the US Federal Reserve is expected implement policies that are likely to improve the general economic conditions, and thus the equity markets.

Wait and watch

The consequences of both suppositions are a rising equity market, but the policy actions taken by the Fed will be different however. In the first case, the Fed might adopt a wait and watch policy as far as its quantitative easing programme is concerned. In the second case, the Fed will go onto conduct the third round of easing, some variant that involves purchases of mortgage-backed securities and US Treasuries from the banks.

The Treasury bears (those who believe yields will rise and thus reduce the value of future coupon payments) have begun to publicly talk up fears of hyperinflation, not just inflation.

The assumption is that as the economy grows, inflationary pressures will accrete thanks to the large amounts of cash infusions made over the past four years, directly or otherwise, into the economy. Resultantly, inflationary expectations will spiral upwards.

Likely to intervene

The key assumption, however, is that growth will manifest. One of the key requirements for recovery and growth however is that yields (and thus the average interest rates in the economy) remain low. Rising rates would most likely slow the pace of growth. Viewed thus the Fed is most likely to intervene in the coming days. But, there is also a subtler point here. If the Fed does give quantitative easing a pass, thus allowing yields to rise, it would be imputed as: (i) confirmation that the Fed too believes that the economy's improvement is progressively on a fast path and the rising yields are acceptable way to tamp down expectations (ii) the cost of rising rates on housing recovery is less than the cost of potentially danger inflationary pressures (iii) the impact of yet another round of quantitative easing is unclear and another round will cause greater macroeconomic risks, thus it ought to be avoided.

Of the three points, (iii) is easier dismissed. The Fed officials have repeatedly suggested any intervention would be sterilised.

This means, they'll likely sell the medium term bonds (5-10 years maturity) and increase rates in that segment of the yield curve; and use the proceeds from that sale to buy the short term bonds (0-5 years maturity). As result the yields on the short end would decline from these purchases.

In net, there would be no new monies introduced into the system. Point (i) can be set aside as well — as the Fed has described that it, at best, expects growth to be moderate. Not enough to be satisfied, especially in an election (even if the Fed is ostensibly an independent institution). Point (ii) is harder to discern — relative cost analysis is always tricky. Yet, by most measures, inflation seem still far away, perhaps at least two years in the future.

 

The columnist works for a major European investment bank in New York City. All opinions are personal and don't reflect any institutional perspectives.