Vigilantes or the Fed: Understanding Monday's Bond Market Dip

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Paul Krugman points out that word from Fitch that a U.S. downgrade is now unlikely because of the debt ceiling has been temporarily suspended seems to have contributed to this morning's Treasury retreat.

"That's right, reduced fears of a downgrade lead to higher, not lower, US borrowing costs," Krugman writes.

That is: news that Fitch considers Treasury bonds less risky pushed down their prices. Or, perhaps even more clearly, investors were less interested in buying Treasury bonds after Fitch declared a downgrade less likely.

Here is Krugman's explanation of this phenomenon:

Why? Because scare talk from the rating agencies feeds the deficit scolds, making destructive austerity more likely, and therefore pushing back the date when the Fed might raise rates. You might say that the only thing we have to fear from the rating agencies is fear itself — not market fear, because the bond markets don't seem to care, but political fear, the instinctive tendency to overreact to talk of bond vigilantes.

What Krugman seems to be saying here is pretty simple—although not uncontroversial. The yields of Treasury bonds reflect the expectations of the path of future interest rates. So policies that the market views as positive for the economy get reflected in higher borrowing costs for the U.S. government—because people believe that an improving economy will result in the Fed raising interest rates earlier. Policies or events that appear to be negative—going off the fiscal cliff, getting downgraded—lower borrowing costs as investors engage in flight to safety trades.

Of course, there's another way of telling this story, one that involves bond vigilantes. The lifting of the debt ceiling—even temporarily—means that the U.S. will continue to issue new debt on top of our already massive debt levels. Investors may actually be growing slightly more wary that the U.S. will bring down its debt to levels considered by many market watchers to be "sustainable."

In short, the story you take away from today's bond market action is probably going to be the same one you came into it with.

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