Chucking Darts

Story Highlights:

• The yield on 10-year US Treasuries has ticked up recently.
• Superficially, it may seem the Fed's quantitative easing campaign is failing to keep long rates low or inflation is on the rise.
• But the Fed buying Treasuries couldn't contain long rates forever. This action's more useful as a source of liquidity alongside already plentiful monetary stimulus.
• Moderately higher long-term rates likely indicate mild inflation, decreased risk aversion, and economic growth to come.
• A steeper yield curve also bolsters bank profits.

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It's easy to find worries these days. Pin up some newspapers (if you can find any left!), cover your eyes, and chuck a dart at the wall—swine flu. Now one over the shoulder—shrinking GDP. And three at a time, under your leg, blindfolded? Toxic assets, government-induced uncertainty, deflation—can't miss. Some risks, like Beltway surprises (not the good kind), are real. Others, like swine flu, have been largely blown out of proportion.

Here's another concern we've seen a few darts sticking to: The 10-year US Treasury yield is on the rise. Superficially, it may seem the Fed's quantitative easing campaign is failing to keep long rates low. Or rising rates reveal the tip of an inflationary iceberg, capable of sinking markets before they get a good head of steam.

But is the Fed's quantitative easing really failing? We don't think so. Keep in mind, the Fed is buying long-term bonds for two reasons. The first aim is to hold long rates down to stimulate lending. But they know that strategy isn't viable forever. The long-term US Treasury market is one of the widest and deepest of all securities markets. $300 billion isn't capable of influencing rates too much for too long.

The second reason the Fed decided to purchase long bonds is more compelling—to further boost liquidity (i.e., cash) in the financial system, yet maintain balance sheet flexibility. As the Fed prints money and exchanges it for long bonds, the money supply will increase no matter what rates do. But if they need to soak up liquidity fast, they can sell Treasuries a lot quicker than other types of debt. And don't forget, the Fed has injected unmatched amounts of monetary stimulus into the system already. Mildly rising or falling Treasury yields don't mean much in the grand scheme of monetary matters.

But what do they tell us? Starting last fall, folks flocked to the safety of Treasuries, driving yields down and prices up—a flight to safety. In the short run, rising yields could mean that trend is reversing, which is good for stocks. The parallel rise in stock prices through March and April seems to indicate investors are willing to stomach more risk right now. But these are highly volatile times, and yields could quickly turn the other way. Hard to know.

If, however, higher rates are sustained, it would most likely reflect expectations for moderate inflation down the road. As long as yields don't go too high too quickly, that's bullish. Mild inflation and healthy economic growth often go hand-in-hand—exactly what Fed policy is trying to accomplish. And as long as the Fed keeps short rates near zero, higher rates on the long end steepen the yield curve. A steep yield curve helps bolster a banking recovery, as banks profit by borrowing funds short term and lending them out long term.

Though modestly higher bond yields aren't worrisome, that doesn't mean we should ignore interest rates completely. Inflation is a risk in the years to come, and long-term government bond yields will likely be the canary in the coal mine. But long-term rates don't reflect significant inflation concerns at present. Stock prices should rise significantly before inflation becomes a meaningful threat. And we don't know about you, but we'd prefer pinning the tail on the bull to chucking darts at distress.