Stocks continued their seemingly relentless climb this holiday-shortened week. The markets opened the week Tuesday with a strong gain, succumbed Wednesday to selling prompted by concerns about rising bond yields, then finished the week with strong performances on Thursday and Friday.

The Dow Jones Industrial Average gained 223 points (2.7 percent) in the week, while the S&P 500 Index rose 32 points (3.6 percent). The markets continue to feed off optimism about the nascent economic recovery. However, worries that rising bond yields could derail the recovery have been keeping investors on the defensive.

The Dollar fell against most major currencies, gaining ground only vs. the Japanese Yen, reflecting investors’ appetite for riskier assets. The Dollar fell 0.7 percent vs. the Euro, 1.3 percent against the Swiss Franc and 1.5 percent vs. the British Pound. The Dollar gained 0.9 percent against the Japanese Yen.

This week, we will focus on the issue of rising bond yields in an effort to determine whether this is sufficient reason to worry about their effect on the markets.



Background

The yield on the US Treasury 10-year bond rose to 3.75 percent Thursday, its highest level since mid-November, before falling back to 3.45 percent on Friday. Thursday’s high point represented a better-than 50 basis-point jump in the yield in a little over one week and compared to a December low of 2.1 percent (when investors were pouring into US Treasuries at the height of the economic crisis).

Longer-term yields have also risen sharply compared to shorter-term maturities, reflected in a considerably steeper yield curve: on Thursday, the spread between the 2-year Treasury note and the 10-year widened to 2.78 percent.

There are two main reasons why yields have risen: Increasing inflationary expectations - investors demanding greater yields to offset the effects of increasing inflation - have pushed up long-term yields. And investors are selling government securities that they purchased at the time of the initial panic in order to shift to other assets. Investors are responding to four major factors: "green shoots" in the economy representing early signs of an economic recovery, an increasing burden of US government debt, the risk of an inflation revival, and a flood of new bond issuances, both by the government and from the corporate arena.



"Green Shoots"

The economic news that the markets responded most to this week was a positive increase in consumer sentiment. On Tuesday, the Conference Board reported that its index of consumer confidence jumped to 54.9 in May, up from 40.8 in April (revised upward from 40.8). A consensus of economists had expected an increase to only 42.6. Then, on Friday, the University of Michigan reported its own index of consumer sentiment rose to 68.7 in May, above expectations of 68.0, and up from 65.6 in April. With consumer spending constituting two-thirds of GDP at the height of the economy, this was welcome news.

Sales of both existing and new homes posted gains in April, although the increase in new home sales fell below expectations. Existing home sales rose 2.9 percent, after falling 3.4 percent in March, while new home sales were up 0.3 percent. Also showing an increase were orders for durable goods (up 1.9 percent in April - their biggest increase since December 2007 - above analysts’ expectations).

The positive news more than outweighed the negative news: the Case-Shiller index of home prices in 20 major cities showed a record drop in prices in the first quarter, with prices in March down 20 percent from year-earlier levels. In addition, the commerce department reported that GDP fell "only" 5.7 percent (annualized) in the first quarter, compared to its earlier report of a 6.1 percent decline.

A survey conducted by the National Association for Business Economics found that more than 90 percent of economists polled believe the US recession will end this year, with about 74 percent expecting the recovery to begin in the third quarter.



The US Debt Burden

With more and more signs pointing to economic recovery, investors are beginning to shift their concern to the growing burden of US debt. Confidence in two key aspects of the government’s program for fighting the crisis - the government’s creditworthiness and the Fed’s ability to manage the money supply - is beginning to waver.

The Obama administration estimates that the budget deficit will hit $1,840 billion this fiscal year - 13 percent of GDP. Unfunded liabilities are currently four times the level of GDP. There are concerns that total public debt, which was 41 per cent of GDP in fiscal year 2008, will climb to 75 percent of GDP by FY2015, and keep rising from there.

The Congressional Budget Office predicts that the US will have a structural deficit (the deficit when the economy is operating at full potential - the economy is currently running about 8 percent below its long-term potential) equal to 5 percent of GDP by 2015. The Obama administration has said that a structural deficit of 5 percent is unsustainable and says it will "adjust" policies if the deficit reaches 3 percent (long-term). The administration has said it is committed to a sustainable fiscal policy.

An unsustainable structural deficit would have to be attacked in two possible ways. Either the government could raise taxes. One economist (John Taylor, Financial Times, May 27) has estimated that it would take ten years at an average tax rate of 60 percent to eliminate the deficit. Or, the Federal Reserve could monetize the deficit. The same economist also estimated that doubling prices over the next ten years could eliminate the deficit - a 100-percent increase in prices over ten years implies an average inflation rate of 10 percent per year. Neither course, I think, would be palatable to the American public.

The debt burden took center stage a week ago when Standard and Poors decided to downgrade its outlook for British sovereign debt to "negative" from "stable." That decision portended the possibility of reducing the UK’s credit rating from AAA to AA. S&P’s decision caused investors to begin looking at the US credit rating as well, with some analysts predicting that the US, too, could be downgraded from AAA. A decrease in the US rating could force more selling of US treasuries and would mean an imminent decline in the Dollar.

This week, however, Moody’s, a second rating service, reaffirmed its Aaa rating for the US. And a number of analysts have said that a US credit-rating downgrade is extremely unlikely in the near future. They also say a possible default by the US will not happen: the US Treasury has taxing power which would allow them to raise taxes to avoid a default. They also point out that a US default would be worse for virtually every other country in the world.



The Risk of an Inflation Revival

With "green shoots" of recovery beginning to appear in the economy, investors are starting to worry about what comes after the recovery kicks in. Both the Administration and the Fed have been spending billions, both to aid the recovery and to avoid deflation. Investors fear that a recovery will lead to runaway inflation, with the Fed, charged with having to mop up this excess liquidity, being overwhelmed with the task.

In the June 1 edition of Business Week, James C. Cooper argues that a rapid return of inflation should not be a concern. He maintains the Fed will have plenty of time to drain the excess. The high level of unemployment in the United States will exert downward pressure on wages and prices for years to come. In addition, the current record amount of idle production capacity in the US will also prevent prices form rising. According to the Congressional Budget Office, at the end of 2009, actual GDP will be running about 8 percent below potential GDP. With potential GDP growing at approximately 2.3 percent per year, actual GDP will have to grow at an annual rate of 4.4 percent just to close the gap by the end of 2011.



The Flood of new Government Debt Issuance

A total of $2,000 billion worth of new government debt is expected this fiscal year. The Treasury has already sold securities totaling $800 billion year-to-date, compared with $922 billion for all of 2008. This past week the government sold $101 billion in securities ($40 billion in 2-year notes on Tuesday, $35 billion worth of 5-years Wednesday, and $26 billion of 7-year notes Thursday). All but the 7-year notes were well-received.

Government securities must now begin to compete with corporate debt, as investors who are willing to seek riskier assets, demand higher yields.

Of concern will be the continued appetite of foreign investors for US government securities. Foreign investors currently hold approximately half $6,000 billion in government securities outstanding. Will they continue to keep buying? In addition, some foreign investors are shifting to shorter-term maturities, shunning the longer-dated issues. According to Credit Suisse, China’s holding of Treasury bills has increased significantly "from just over 1 percent of outstanding bills to nearly 10 percent recently". Their share of note and bond holdings "fell from a peak of 15.1 percent in August 2008 to 13.7 percent in March"



Are Rates High Enough to Derail the Recovery?

As we pointed out, the 10-year yield, currently at 3.5-3.7 percent, has risen from a level of about 2 percent, when the Fed first announced its intention to begin buying bonds - its embarkation on quantitative easing. But they are still well below the 5-percent level reached two years ago when the economy first slipped into recession. We believe yields still have a way to go before they really become a concern.