Interest rates surged across the entire maturity range of U.S. Treasuries last week, by an eye-popping 35 basis points on 2-year Treasury notes and a still significant 12 basis points on 10-year notes. A variety of explanations have been offered in explaination: inflation expectations are ratcheting higher, the Treasury will be auctioning off a seemingly unlimited supply of new issues to finance the ballooning deficit, or that an economic recovery appears to be at hand. Only the last of these possibilities is convincing.
There is much speculation—far too much in this author’s opinion—that inflation will soar as a result of the flood of liquidity injected by the Fed. This logic is woefully lacking, since it avoids all the intermediate steps between injecting liquidity to driving up prices. Glossing over the rise in unemployment and the fall in capacity utilization makes it unnecessary to explain why wage rates might rise sharply or where firms will find pricing power. Before inflation can rise meaningfully, the economy will need to get much stronger, so it is highly premature for inflation to drive up interest rates quite yet. Near term, inflation is still more likely to slow down.
Ever larger and more frequent Treasury auctions are adding to the supply of Treasury debt, which could push prices down and yields up. However, the Fed is buying Treasuries for its own account, while foreign central banks continue to add to their holdings. Moreover, increased supply was certainly no obstacle to rates falling when the economy was quite weak and the credit markets were convulsing. By itself, it is very unlikely that increased supply would drive up rates so much, so quickly, particularly over the past week when little new debt was issued.