The slowing expansion of the U.S. Federal Reserve's (Fed) balance sheet, a continuing drawdown of banks' excess reserves and rising long-term interest rates indicate that the wary dialogue between bond markets and the monetary policy has entered uncharted territory.
At the end of May, the Fed's $3.9 trillion monetary base (a four-fold increase from pre-crisis levels) was only $14.8 billion above its level at the beginning of this year, and its annual growth rate has virtually ground to a halt.
Banks' extraordinarily large loanable funds of $2.5 trillion (in 'normal' times they are $1.5-$2 billion) are showing a more pronounced slowing pattern: they are down $31.9 billion in the first five months of this year and 2.4 percent below the level of May 2014.
Bond markets have reacted to these liquidity contractions by pushing up the yields on long-term securities. Last Friday, the 2.39 percent yield on the benchmark ten-year Treasury note was 71 basis points above its most recent record-low level in early February.
By raising the longer end of the yield curve, bond investors are anticipating the beginning of the Fed's tightening process, even though the Fed's policy interest rate – the cost of overnight money – still continues to fluctuate around half of its 0.25 percent official target.
Don't believe the declinists
Being the key lenders to the government, bond markets are constantly adjusting their views of the monetary policy. They do that by changing the nominal yields they demand to cover the expected risks to real returns on their loans to the U.S. Treasury.