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For Now, Big Jump in Yields Being Seen as Good Thing

Rising interest rates for now are generating views that the economic glass is half-full, even though the trend would seem to counteract aggressive monetary policy from the Federal Reserve.

The 10-year Treasury note yield—seen as the benchmark both for government securities and lending rates—reached six-month highs Monday before pulling back, and the trend appears solidly skewed to the upside.

While the last significant rise in rates preceded a sharp market dropoff through the summer, most economists think the current scenario of upward trends in growth and stock market prices tells a different story.

"We had a period very early in the year of excessive, robust enthusiasm about growth. Then we got into excessive pessimism about growth," said Kurt Karl, chief US economist at Swiss Re in New York. "We're heading back to what's about right."

That trend toward equilibrium has caused many strategists lately to up their forecastsboth for economic growth and stock prices in 2011.

That comes even though the Fed's second round of monetary easing, done through a program of quantitative easing that entails purchasing $600 billion of Treasurys, ostensibly should have lowered rates. QE2, as it is called, creates artificial demand for government securities, which by design would drive up prices and lower rates.

But the Fed's long-expected announcement Nov. 3 that it was launching QE2 instead preceded a move higher in rates. Economists say that's because the easing has increased confidence the central bank will continue to intervene in the economy, and they say rates might be even higher had the Fed not intervened.

"Speculation that policy has failed or that officials might throttle back in the wake of fiscal developments is misplaced," Robert V. DiClemente, chief US economist at Citigroup, said in a research note to clients. "Higher Treasury yields are an unavoidable by-product of an improving outlook borne out in the broader array of financial conditions."

Rather than simple rate movements, it may be more worthwhile to watch consumer and investor behavior.

"The end goal of QE2 and what the Fed is trying to achieve is increase confidence in the economic situation," says Gary Flam, portfolio manager at Bel Air Investment Advisors in Los Angeles. "That gets people to spend money, whether it's capex (capital expenditures) or by consumers on the holidays. Their goal is not to drive down rates, but to use lower rates to achieve the end goal, which is to increase confidence in the economy."

To be sure, investors have stepped fairly cautiously into the rate climate, with outflows from equity funds abating somewhat while bond funds have ended a long streak of inflows.

But expecting a large flow of money from bond funds into equity funds may not be realistic.

Market research firm TrimTabs points out that much of the money flow to bond funds during the boom of the previous six months came from other safety instruments like money markets, not necessarily from equities. Corporate insiders, meanwhile, continue to exit the market, selling $11.6 billion in November and $3.4 billion so far in December.

Indeed, it's been more than basic economic hopes that have driven rates higher.

Other factors include the possibility the Fed may be in its final phase of easing; worries that fiscal stimulus could add to debts and deficits; the tamping down—for now—of worries over European sovereign debt defaults, and inflation expectations.

"These factors are interrelated so it is impossible to be precise about exactly how much of the rise in yields should be attributed to each factor," Julian Jessop, chief international economist at Capital Economics in London, wrote in a note to clients. "However, we would give most weight to growing optimism about the outlook for economic growth and the impact this has had on the expectations for monetary policy."

And lest there be fear that yields may interfere with economic growth, Jessop thinks the current spike will be temporaryand likely ease on the realization that even if the economy is in growth mode, movements are likely to be gradual.

"Admittedly, yields may rise further in the coming months given the wide range of bearish arguments in play (perhaps even to levels that start to undermine the economy recovery)," he wrote. "But they are likely to fall again next year in anticipation of a renewed slowdown in 2012."

That sentiment mostly jibes with investor sentiment that is at worst cautiously bullish on stocks and mostly unafraid of inflation, at least for the moment.

"There's still significant headwinds facing the economy: 2010 stimulus rolls off and is less helpful, concerns about Build America Bonds not being renewed, and you still have states in fiscal deficits," Flam said. "Runaway economic growth and inflation that follows, at this point, is far from our minds."

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