I was thinking on Friday about the 10-year treasury yield. I have recently calculated an adjusted yield that accounts for the zero lower bound on short-term interest rates, and found that “zero” at the 10-year point is around 1.7%. Presently, the 10-year is trading around 2% and has hit something of a floor — in other words, the possibility that short-term interest rates could stay flat for the next ten years may be fully priced in, before one even thinks about inflation or credit risk or a liquidity premium. Considering the cheapness of shorting the 10-year Treasury at present, I thought that there might be a trade here. There is an obvious objection, however, which is that Japanese 10-year yields have generally been below 1.7% in the years that short-term rates have remained at zero, and have found a ceiling, not a floor, at 2%. The most plausible response to this objection is to point out that Japan has had deflation, so real yields have been higher than nominal yields; but it might also be that the expected volatility of future short-term rates has been depressed by Japan’s long slump, which would reduce the effective “zero” level at the 10-year point. Helpfully, the fact that the long-term inflation expectation (as implied by the breakeven on 10-year TIPS) in the US remains at around 2% means that neither explanation is likely to apply to the US at present: deflation is not expected; and if interest rates are expected to remain on target then, to a first approximation, upside and downside risks to future inflation are seen as balanced, so it is just as plausible that interest rates will have to rise in the future as it has been in the past. With the short-term economic picture improving in the US and rates not much higher today than they were when a double-dip recession looked a distinct possibility, there seems to be a good argument for a bet on a rising 10-year Treasury yield, i.e. a short on 10-year Treasuries.

Events in Europe are still moving, though it is easy to forget it when the subject falls out of the news. Mario Monti has announced that there will be no further spending cuts in Italy in 2013 than those already planned, and the government’s deficit target will be met by boosting growth (thanks to various government reforms). I am far from convinced that this plan will work on such a short time scale and expect Italy to miss its deficit/GDP target in 2013 if current policy is pursued. The level of public-sector involvement in Greece’s restructuring is still under discussion, with a conclusion possible this week; a write-off of up to 70% has been talked about. There may be a trade here (long Greek bonds) once some hard numbers are available.

China appears to be easing its monetary policy, with a recent cut in reserve requirements and an increase in new loans last month. This is the behaviour I expected from the Chinese government — it is more afraid of a slowdown than it is of inflation and it will err on the side of caution when it comes to maintaining growth. However, I was not clear in my mind about the effect of the time lags involved when I was writing about this question a year ago. I did not understand clearly enough that there would be time for a slowing of Chinese growth before the government would act, and thus for a fall in commodity prices; indeed, there is still time for further slowing to occur. Happily, my excessively bearish but directionally correct view on US assets and my correct assessment of the European situation, together with the observation that continued Chinese growth did not prevent falls in commodity prices during the financial crisis, kept me inclined to be bearish and helped me to avoid losing money.

Data:

German factory orders -4.8% d.e. Nov. Almost reverses last month’s leap.
Non-farm payrolls 200k b.e. Dec.
Unemployment rate 8.5% b.e. Dec. Lowest since Q1 2009.
China new loans increased MOM, b.e.
China M2 13.6% YOY b.e.
New Zealand trade deficit widenend slightly, d.e.
Australia new home sales 6.8% MOM. A second strong months, coming after the summer’s large falls.
Australia retail sales 0% d.e.
German trade surplus increased to a strong level, b.e., Nov. Exports rose, reversing last month’s fall, and imports fell slightly.
French trade deficit narrowed, b.e., Nov. Exports rose, reversing last month’s fall, and imports rose only slightly.

This Week:

Mon: German IP.
Tue: China trade balance (may be Tue-Fri); French IP.
Wed: UK trade balance; US Beige Book.
Thu: ECB rate; MPC rate; China CPI; UK manufacturing production; Eurozone IP; US retail sales, initial claims, business inventories and federal budget balance.
Fri: UK PPI; US trade balance and prelim. Michigan sentiment.
Sun: Japan machinery orders.

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