It's my impression that most market participants have been persuaded by the flow argument: namely, that the Fed's massive QE3 purchases have artificially depressed market interest rates. After all, that's been the Fed's stated intention: to buy lots of bonds in order to depress interest rates and thereby stimulate borrowing and economic activity. This line of reasoning says that the fact that 10-yr Treasury yields averaged an exceptionally low 1.75% over the past year has nothing to do with the market's view of inflation or economic growth; Treasury yields have in fact become meaningless inputs to valuation models and offer no insight into market and economic fundamentals, other than as a distorting influence.
I've argued to the contrary on many occasions over the years. I believe that interest rates are determined by the market's willingness to hold the existing stock of bonds, especially since Fed purchases on the margin represent only a small fraction of the existing stock. I think the Fed can only influence yields to the extent that the market's view of the economy is similar to the Fed's. If both expect the economy to be very weak, yields will be low, and prices will behave as if Fed purchases of bonds to stimulate the economy are in fact achieving their stated objective. But if the market thinks the economy is improving and/or inflation is rising, then no amount of Fed purchases will be able to keep yields from rising. That's the situation today, and it's been unfolding (in fits and starts) almost from the day QE3 began.
And so it is that despite the Fed's purchases of $45 billion of Treasury notes and bonds every month, and $40 billion of MBS every month, 10-year Treasury yields have jumped some 80 bps and MBS yields have jumped almost 100 bps:
What has changed since the beginning of last month that has caused Treasury yields to soar? Only one thing: The market has come to believe that indeed -- as the FOMC's recent statement suggested -- the outlook for the economy has improved a bit. The Fed has been telling us for a very long time that it would eventually stop buying bonds, but until recently the market just didn't believe it would ever come to that; the market thought the economy would be mired in a slump for as far as the eye could see. The "new normal" economy was going to last forever.
Now, however, the market is beginning to see some light at the end of the "new normal" tunnel -- things might be getting better. And of course, if the economy does improve, then the Fed will not only taper and then stop its QE purchases, but it will sooner or later begin to push short-term interest rates up. Even if the Fed waits until next year to raise short-term interest rates, which seems likely, the market can now believe that short-term interest rates will rise, and so today the market is adjusting to what it believes will happen in the next several years.
If the market thinks the economy is improving and/or inflation is rising, then no amount of Fed purchases will be able to keep yields from rising. That is what today's market action is all about.
So it makes sense for Treasury and TIPS prices to be plunging/yields to be rising, because the market now believes that interest rates will be higher in the future than it thought until recently. And it makes sense for inflation expectations (as measured by the spread between TIPS and Treasury yields) to be declining, because the Fed is now less likely to make a big inflationary mistake.