Friday, September 25, 2009

The Treasury Market Has It About Right

Financial markets are not exactly known for being rational entities, having a deeply ingrained penchant for overreactions that often make them swing from one extreme to the other, while bypassing the more sensible middle ground. So, it is a fairly rare situation to see a market being reasonably priced, reflecting a balanced approach toward the overall economic environment and its prospects. The Treasury market seems to be such an example in its current phase.

The long end of the Treasury market has experienced some particularly major swings in the last year or so, in the midst of what has admittedly been an unusual financial and economic environment. The 10-year yield went through its wild "deflation is coming because this is the Great Depression all over again" stage late last year, causing its yield to plunge close to the historically unprecedented 2% mark last December, to the "inflation is coming because the economy is roaring ahead and the Fed will be asleep at the wheel" phase, sending its yield up to 4% just six months later.

Since late June though, long-term rates have settled down considerably, with the 10-year yield staying essentially between 3 1/4% and 3 3/4% , and, in fact, spending most of its time closer to the middle of that already relatively narrow bracket. That range reflects a reasonable assessment of the medium-term outlook for both the economy and Fed policy, as it implicitly incorporates the assumption of a moderate economic recovery (the initial momentum of which may be subsequently tempered by a number of much-analyzed headwinds), an alert but supportive monetary policy, and a backdrop of subdued inflation pressures.

Unless there is a fundamental re-examination of the entire outlook ahead, presumably caused by a radical change in the tone of the various economic releases or unexpected headline events, the 3 1/4 to 3 3/4% range should hold for the foreseeable future, always allowing for fairly short "excursions" to neighbouring yield levels. In the meantime, plain, old-fashioned, carry trades should continue to hold their appeal.