Thursday, May 7, 2009

The Logic of Optimism

The fanfare and anticipation surrounding the release of the vaunted stress-test results have overshadowed certain adverse developments within the US Treasury market. Once again, a Treasury auction has been met with anemic demand. In this instance, the bastardized portion of the curve was the 30 year bond. We have warned of these developments in the past, portraying the situation as analogous to a sputtering car engine in need of repair. Additionally, the yield on the 10 year note continued to rise, reaching 3.2950%. Apparently, the Fed will defend neither 3%, nor 3.25%. Mortgage rates have followed suit, and as indicated by BankRate, the average rate of a 30 year fixed mortgage is now above 5%.

The typical market/economic optimist, engrossed in the stock-pumping rhetoric of the various market television shows, would argue that as the Fed/Treasury have instilled confidence in the Market, and as investors have become less risk averse, they have collectively shifted capital from the safe haven of Treasuries back into the equity markets. Therefore, according to the purveyors of happy-talk, this Treasury market behavior is only what is to be expected. Unfortunately, this sort of reasoning presents us with a logical quandary.

Assumption: The Government/Fed actions to date have been vital in restoring the economy's health. 

If the stock market is to continue its rally, Then the flow of money from the Treasury to the equity markets should continue. If money continues to leave the Treasury market, Then the yield on the 10 year and other Treasury issues will rise AND the interest rates of mortgages and other consumer finance instruments will rise. If the cost to finance mortgage/consumer/auto loans continues to rise, Then the Fed's allocation of $1.3Trillion to these markets will have been rendered useless. If the Fed is rendered useless, Then the economy will resume its fall.

Therefore, If the stock market continues to rally, Then the economy will resume its fall.
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