Listening to the market—not the pundits

Posted by on July 29, 2011 @ 1:50 pm in Economy & markets

Everyone who is not on vacation appears to be focused on the uncertainty created by the lack of a resolution to the most recent government funding crisis. I wish I could add some value with respect to the discussion of the “default” issue or, even better, predict what the final outcome will be. I can’t.

And of course my own views on the subject ultimately don’t matter much. In fact, they probably matter even less than the views of people we’re all watching on TV and reading in the press who are paid on the basis of how well they can attract and retain attention in the mainstream media.

While I have no private information of my own to add to the discussion, what I can do is direct your attention to some very public information in this data series (which you can replicate, manipulate, or further examine here: http://research.stlouisfed.org/fred2/graph/?g=1iS), which shows the inflation-adjusted yield to maturity on the U.S. Treasury Inflation-Indexed Note due January 15, 2014. This gives you some sense of what investors trading U.S. government debt have been thinking about the value of Uncle Sam’s promise to make inflation-adjusted interest payments and principal repayments through 2014. The views of these folks matter much more than mine—and much more than the views of pundits.

10–Year 2% Treasury Inflation-Indexed Note, due January 15, 2014

10-Year 2% Treasury Inflation-Indexed Note, due January 15, 2014

Sources: Chart provided by Federal Reserve Bank of St. Louis. Data by Haver Analytics and Dow Jones & Co.

The chart shows that as the hyperbole about the funding crisis has peaked in the last few weeks, the yields on this inflation-indexed U.S. Treasury note have actually stopped falling. (Recall from Investments 101 that if there were increasing doubt among investors with respect to whether they would be paid interest and principal on any bond, the yield on that bond would rise because the price would be falling.)

The takeaway is that those who are buying and selling this particular note are apparently still seeing what is happening in Washington as political theater. As of July 27, buyers and sellers had perceived no immediate threat that would cause a radical revision in their assessment of the value of this note (other T-notes and bonds show somewhat similar patterns). In fact, in this case, the government’s promise to pay principal and interest in inflation-adjusted terms is seen as so valuable that investors are, as of July 27, willing to accept a rate of return slightly less than equal to inflation for the privilege of getting their money back in two years (which is just another way of saying the yield is negative, as shown on the chart).

Of course, markets and investors can be wrong. These prices for inflation-indexed T-notes reflect nothing more than the consensus (or market clearing) value of this form of U.S. debt. But at this stage, the “midpoint” of expectations around what will happen with respect to federal interest payments hasn’t budged much.

Anyone with skin in the game who disagrees with the market’s assessment is now, and has been, free to sell their stake in this note or others, and walk away with “non-defaultable” cash. The bottom line is that this hasn’t happened … yet.

While this could, of course, change quickly, the market still expects a deal.

(I do, too.)

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