Interest Rate Watch

Treasury yields moved sharply higher this week as fears about the European Financial Crisis subsided and confidence about the strength and sustainability of the U.S. economic recovery continued to improve. The early release of the Fed’s bank stress test results also buoyed confidence and the stock market. The joy and jubilation has taken the equity market to its highest levels since June 2008. Given the recent run of stronger economic reports and reduction in fears about Europe and the global financial system in general, yields were way too low.

So how much higher will Treasury yields rise? Reversals in the bond market can be quite sharp, as their timing is difficult to anticipate. With the inflation reports behind us, we see little prospect for disappointing economic news until early April, when first quarter earnings begin to trickle in. April will present an important test to the economy and financial markets.

Recent productivity trends suggest profits could disappoint on a number of fronts. The March inflation data, which comes out in the midmonth, may also be less friendly. While core inflation was well behaved in February, there were a number of declines that are not likely to continue, including a drop in core services prices and a big drop in apparel prices. Sooner or later, higher gasoline prices are also likely to push food prices higher, and the recent jump in airfares does not seem to be in the data.

April has also been the month were the economic news turned more cautious during the past two years, with consumer confidence plunging and jobless claims beginning to trend up.

The FOMC policy statement was a little more upbeat than the prior report, but the Fed is still clearly keeping its options open. We continue to believe that the Fed will opt to increase its purchases of mortgage backed securities this spring to hold mortgage rates down as much as possible during the important spring selling season. With the wind finally at its back, a modest, well-timed policy move by the Fed may be more effective than anything attempted so far.