Tuesday, December 07, 2010

Bond Market Reaction To Tax Deal

While as usual the actual yield changes constantly changes, so that it will probably be different when most readers read this, the changes now are still significant enough to report on. The yield on regular Treasury securities are up 21 basis points on both the 5-year and 10-year security. Meanwhile, the yield on inflation protected Treasury securities are up 12 basis points for 5-year securities and 13 basis points for 10-year securities.

Thus bond investors anticipate both higher inflation and a "crowding out" effect in the form of higher real interest rates from this deal of cancelled tax increases, tax cuts and cancelled spending cuts. While bond markets often react in an irrational way, this reaction is in fact very rational. A more "stimulative" fiscal policy will in fact increase consumer price inflation, and to the extent that Ricardian equivalence doesn't hold (and to the extent the trade deficit doesn't increase), it will also raise real interest rates.