Thursday, December 9, 2010

The Bond Market Does Not Like the Tax Deal


Treasury prices fell on Wednesday, pushing yields on 10-year notes to the highest level since June, as investors signal worry that the U.S. is not dealing with its budget deficit.

Yields on 10-year notes /quotes/comstock/31*!ust10y (UST10Y 3.26, -0.01, -0.40%) , which move inversely to prices, rose 10 basis points to 3.24%.

The yields touched 3.34%, the highest level in six months and up from 2.94% on Monday -- still the biggest 2-day increase since June 2009 in late afternoon trading.

Yields on 2-year notes /quotes/comstock/31*!ust2yr (UST2YR 0.61, -0.02, -3.19%) rose 9 basis points to 0.62%, having touched the highest since July: 0.65%.


On Tuesday, yields jumped by the most since June 2009 after the White House and Republicans revealed a tax-compromise bill that is expected to boost consumer spending and growth, but also increase the federal deficit and trigger more debt issuance. See story on Obama, tax deal.

Let's go to the chart:

Prices were stable on Monday (a), but gapped lower on Tuesday morning and moved lower throughout the day, hitting resistance at the EMAs (c). Prices gapped lower again yesterday (d), but rallied back to near the open by the close. Prices have dropped 2.58% in the last three days -- which is a pretty big move for the bond market, unless there is a fundamental problem. Bonds just aren't that volatile. So, when we see a 30 basis point increase in the yield on the 10-year in a few days, we should take notice.

Here's the deal: as NDD and I mentioned yesterday, the tax deal is not about cutting the deficit, which is really ironic in a very painful way because all we've heard for the last two years is how we need to get the deficit under control. In addition, considering that personal income taxes as a percent go GDP are near their historical norm and total federal taxes are near 60 year lows, it's not as though we are being taxed to death.

The short version is the only way to deal with the deficit is to raise taxes and cut spending; the gap between expenditures and receipts at the federal level is simply too wide to be tackled with any other methodology.

Update: A commenter has added that Krugman has argued this is a sign of recovery, a point I made in today's market report:

So -- we have a rising stock market and declining bond market. This is usually the beginning of the second part of the market moves in a bull market. In the first, both Treasuries and stocks rally. Treasuries rally because there is still concern about the economy and little fear of an increase in rates, while equities rally in anticipation of recovery. In the second part of the rally, Treasuries start to sell off as the safe money starts to move into the riskier parts of the market.

However, one point I didn't factor into my previous statement was the timing of the bond market sell-off (which started in earnest this week) and the depth of the sell-off (2.5% in two days). I believe a gradual sell-off in bonds would be more indicative of a move from fixed income to equities -- say a 5% drop in bonds over a month. That being said, Krugman's observations are also a valid interpretation of recent bond market events.