There Is No "Reverse Conundrum" Driving Up Bond Yields

Market pricing so far is consistent with traders (and Fed officials) correcting bets on growth that were overly pessimistic.

The Federal Reserve began “recalibrating” short-term interest rates on September 18. By mid-December, the policy band had been lowered from the peak of 5.25%-5.5% to 4.25%-4.5%, which is where rates currently sit. Over the same period of time, the yield on the 10-year U.S. Treasury note has gone up by a full percentage point. Torsten Sløk at Apollo points out that this is unusual compared to most prior cutting cycles¹ and Paul Krugman wonders whether the U.S. may be paying an “insanity premium”.²

It all reminds me of what happened almost exactly 20 years ago, when Fed officials and others were perplexed by the sharp decline in longer-term yields shortly after the central bank had begun raising short-term interest rates. Alan Greenspan, then the Fed’s chairman, famously declared it a “conundrum”. At the time, there were vigorous arguments about whether foreign reserve accumulation was impairing the Fed’s monetary transmission mechanism. Now we seem to have a “reverse conundrum”, possibly explained by fears of severe policy errors and/or looming institutional breakdown.

While I would not want to write off the possibility completely, I think there is a simpler explanation: interest rate pricing in mid-September was extremely odd, and it is less odd now. The relative changes in rates over the past few months look strange in isolation, but make much more sense when viewed from the perspective of the unusual starting position.