The expectations for inflation and fear of accelerated rate hikes on the part of the Fed seem to be driving the stock market correction in the US this February, 2018, and as a result of the jobs report on Friday, February 2.

As a measure of inflation, the 10 year Treasury notes yields are inching higher, close now to 2.9 percent.

I want to ask what is the connection between inflation expectations and the "tepid demand" for Treasuries in the most recent auctions (10 year notes).

Presumably yields at the auctions are perfectly fine-tuned to meet supply and demand. Therefore, if the issue was simply an expectation of higher yields in the near future, this would have been factored in at the time of the auctions.

At this point the fiscal hole of $1 trillion created by the recently enacted tax cuts is already known. Presumably, economists still see US Treasuries as risk free. And there is the "flight-to-safety" effect, which would anticipate investors fleeing the stock market to seek refuge in US Treasuries, and is seemingly absent here...

So what is behind the "tepid demand"? Is it in some way connected to the main issue of inflation concerns at a technical level, or is it a parallel topic (e.g. institutional trust)?

I am not asking for an opinion-based answer, but a beginner's account of the technical connections between these concepts to the extent that this is possible.


1 Answer 1


There’s a few points to cover in this question.

  1. The description of market events in newspapers is not necessarily reliable. The job of a newspaper editor is to sell newspapers. Readers of the business press like to hear that government borrowing raises interest rates, and so the editors give them that story - a lot. Financial market analysts are paid to give good forecasts, and their explanations are often quite different. (That assertion is based on my experience of writing and reading interest rate commentary.) In this case, the newspaper account may be an accurate reading, but you must keep in mind the prior knowledge that they blame practically every tick up in yields on fiscal policy.
  2. Treasury bond auctions are announced in advance, with the amounts fixed. (They move around money market auctions to deal with fluctuations in cash.) the sizes are based on a lot of consultations with the Primary Dealers and investors, and internal analysis. However, since they fixed the quantity, the price (yield) has to swing. If investors think the yield is too low, it will affect the bids at auction. Going into the auction, there is “when issued” trading, which is based on where dealers think the auction will clear. If they are wrong about demand, actual yields will not end up where the “when issued” pricing was, and the whole curve moves. (Dealers will end up receiving more bonds than they expected, and so will have to trade out of their larger-than-desired duration position.) This dynamic is behind the legitimate stories about tepid auction demand.
  3. The best approximation of inflation expectations is to look at the spread between conventional bonds and TIPS (inflation-linked Treasury securities). The spread roughly equals the future rate of inflation that gives the two securities equal returns. E.g., if the 10-year nominal yield is 4%, and the 10-year TIPS yield is 2%, an inflation rate of 2% results in the two securities having the same return. (One can argue that there are risk premia that drives this breakeven inflation rate away from the true expectation.) There is no guarantee that inflation expectations (by this measure) and nominal interest rates move in the same direction, so one should not use the concepts interchangeably.
  4. The usual explanation for the linkage between higher future deficits and higher nominal interest rates is that “all else equal”, a relaxation of fiscal policy would result in higher nominal GDP (with higher inflation). The presumption is that the Federal Reserve would raise interest rates to keep inflation near its implicit target (offsetting fiscal policy). The expected change in the policy rate affects nominal bond pricing. The exact mix of what happens depends on the specifics of the change to fiscal policy, and your beliefs how fiscal policy works. In any event, all the bond market participants care about is what the Fed does. Otherwise, stories that increasing fiscal deficits raise interest rates run into the counter-example of modern Japan. The debate about that effect is highly political. See also this question: link to question on interest rates and deficits
  • $\begingroup$ Thank you (+1). If I read you correctly, the message is that since every big player (e.g. Japan) is living off their credit, fiscal deficits are a "whatever" issue, because at the end of the day, the Fed can swallow up any excess offer of government bonds, and bring inflation down to its target. $\endgroup$ Feb 9, 2018 at 14:55
  • $\begingroup$ The argument is fairly basic. If the government net spends \$1 billion, that represents a \$1 billion cash inflow into the “non-Federal Government sector.” That spending works its way into the monetary base and/or Treasury debt. So there’s a circular flow, which is what allows nominal debt levels to rise. Pricing is the problem, not raw supply and demand. $\endgroup$ Feb 9, 2018 at 16:14
  • $\begingroup$ If you have it in you to bear with me for a follow-up clarification: "That spending works its way into the monetary base and/or Treasury debt. So there is a circular flow..." Without any interest in any political take, the circular flow would be: Foreign or domestic investors (or the Fed) buy Treasuries -> The US Gov't spends in programs -> Monetary base expands -> Nominal inflation (and nominal GDP) increase -> Fed raises short-term rates -> Treasury yields eventually go up, although not necessarily (see Japan)? Is this a raw summary of your last paragraph? $\endgroup$ Feb 9, 2018 at 18:32
  • $\begingroup$ The way in which increased spending affects the economy can be debated, and I want to stay clear of that debate. There are other questions on that, perhaps I could find links. My view is that the general expectation is that loosening fiscal policy raises expected nominal growth; the central bank raises rates to keep inflation controlled. Bond pricing depends on the change of rate expectations, there is no good link between “supply” and bond yields (my view, again). There is no need to worry about linkages between money, bonds, etc. $\endgroup$ Feb 9, 2018 at 18:58

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