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The Global Radar Screen
The US bond market rallied this week, with the 10-year yield apparently ready to push through 3%, confounding a number of analysts (including us) who had looked for higher rates this year. A combination of higher growth, rising headline and core inflation, and sovereign debt concerns would weigh on bonds, we thought. While we may still be right in the long run, we have been wrong in the short run. While inflation has picked up as we predicted, GDP growth has been disappointing and we have recently cut our GDP forecast to a below consensus forecast 2 ½%. The price action in bond land seems to suggest that even 2 ½% GDP growth this year may be a stretch and has led some to think that the Fed might have to reverse the exit strategy yet again and adopt “QE forever” particularly since there is little real interest within the Beltway to fund another fiscal stimulus program. While exiting the exit strategy is not the consensus feeling regarding the Fed, the renewed rally in bonds may be more reflective of a belief that the U.S. will undertake serious medium-term fiscal consolidation, sparked by the more immediate need to pass a debt ceiling extension this summer. (This feeling is not shared in the sovereign CDS market at the moment, however). A sizeable deficit reduction plan might restrain GDP growth by 0.5 to 1.0 percent starting in 2013, suggesting that monetary policy might have be easier over the intermediate term to compensate. This means that it might be a very, very long time before the federal funds rate returns to the 3% to 4% range that many consider neutral. In what many think will be a sluggish growth environment as we work through the lengthy post-crisis deleveraging, this tight fiscal/loose money policy mix might keep rates lower for longer. So a 3% 10-year might be attractive if you think the U.S. might go the way of Japan, where 10-year yields are running with a perpetual “1” handle.