What a Strange Round Trip It Has Been

In the months after Lehman’s fall, yields on regular Treasuries plummeted in a massive flight to liquidity, while yields on less-liquid inflation-indexed bonds rose sharply. Those moves have reversed in recent months bringing both 10-year Treasury yields back to where they started.

Treasury yields have been surging.  The yield on 10-year Treasuries, for example, closed at 3.71 percent on Wednesday, up more than 60 basis points over the past two weeks.  That’s a big move.

Economic commentators are grappling to understand the causes and implications of this increase.  Is it the return of bond vigilantes worrying about the grim U.S. fiscal situation?  Concern that aggressive policy actions will ignite inflationary pressures?  Or, perhaps, just a sign of healing in the financial markets?

I don’t have an answer for you today.  But I did find one tidbit that suggests that there’s something to the healing hypothesis.  Treasury yields – on both regular 10-year bonds and their inflation-indexed equivalents – are almost exactly where they were before the fall of Lehman:

                                    9/12/2008                           5/27/2009

     Regular                      3.74%                                      3.71%                                   

     Inflation-Indexed       1.79%                                      1.83%

In the months after Lehman’s fall, yields on regular Treasuries plummeted in a massive flight to liquidity, while yields on less-liquid inflation-indexed bonds rose sharply.

Those moves have reversed in recent months bringing both 10-year Treasury yields back to where they started.

Source: Federal Reserve Board, Release H.15

3 thoughts on “What a Strange Round Trip It Has Been”

  1. Our of curiousity, how do you distinguish between a flight to liquidity versus a flight to quality? Treasuries are good on both dimensions.

  2. @Will: Welcome! My intuition is that regular Treasuries and inflation-indexed Treasuries are of comparable quality, in the sense that they are equally unlikely to face default. Regular Treasuries soared during the depth of the crisis (and their yields plummeted), while the reverse happened for inflation-indexed Treasuries. Some commentators would tell you that’s because of fear of deflation, but I think liquidity is much more of the story. For example, deflation shouldn’t cause yields on TIPS to rise. What do you think?

  3. Interesting. Didn’t know that the yields on the inflation-indexed Treasuries had not also plummetted, and I gather that they are not as liquid as the regular Treasuries. So, that would support your view. Still, it seems to me that the fear of default on other securities was so heightened that a quality issue must have been at work as well. As you probably know, there is a significant amount of regulatory action and litigation against the banks that set up the auction-rate securities market, precisely because the liquidity for those assets evaporated in early 2008 even though they had been marketed as being near-cash by the banks. It will be interesting to see how the markets for these and similar assets recovers, or not, from the trauma of the past year.

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