What Just Happened.

Exactly one year ago, markets were deeply rattled when the Treasury Department announced it would need to raise a lot more debt than previously expected.

Normally, these "refunding" announcements are met with a shrug. But not that one. The fact that our government needed to raise $274 billion more than was estimated just three months prior--for $1 trillion total in the third quarter last year--sent markets into a tailspin. The 10-year Treasury yield soared to 5% by October, while the S&P sank to 4,103 as investors came to grips with just how bad our deficit and debt situation was getting.  

Well, what a difference a year makes. This year, the exact opposite happened. Treasury on Monday just revised down its borrowing needs by $107 billion, to "just" $740 billion for the third quarter. And that is a big reason why bond yields have been dropping this week, along with Middle East tensions, and more signs of U.S. disinflation (like softer wages and drooping sales for high-cost goods). 

 The 10-year Treasury yield--a key benchmark for mortgage rates, among other things--is now all the way back down to 4.1% as of this writing. It has almost fully reversed, in other words, the upward spike that started a year ago on fiscal concerns. As for the S&P 500, it's soared to 5,503. 

No one thinks we're "out of the woods" on the fiscal front just because of these developments. But bond yields have an amplifying effect on the deficit front. The higher they go, the worse the deficit gets because interest costs are now half to two-thirds of that annual shortfall. The flipside is that the lower yields go--like now--the better the fiscal dynamics get. So, falling yields drive less Treasury borrowing needs, which drives further declines in yields, and so on. 

Two final points: One, Treasury ought to start terming out its debt as long-term yields fall. They've been over-relying on short-term bill issuance--at yields well above 5%--to the chagrin of many. And second, if the 10-year drops below 4%, some will view that as a reason to be concerned. Michael Hartnett at Bank of America warns it will put "hard landing" worries back on the front burner, which could spark a stock-market selloff. 

The best possible outcome is one that sees continued declines in bond yields alongside better news on the fiscal front and better economic data. With the S&P at these prices, earnings need to be rock solid in the coming quarters. 

And quickly, on China. The country's economic problems threaten to undermine the rosy earnings scenario U.S. investors want. Starbucks sales in China dropped 14% last quarter. Procter & Gamble said China sales sank 8%. McDonald's sales also declined. Visa, Coke, Pepsi, General Mills, Nike, and a variety of luxury brands are also seeing challenges. Burberry's China sales plunged 21%! 

The country is still battling--and exporting--deflation. GDP growth last quarter was worse than expected (at 4.8% if you trust the official numbers). And its "third plenum" was widely viewed as a disappointment to those hoping for better economic news or real progress in moving toward a more consumption-led economy, as China has been supposedly trying to do for more than a decade.  

In fact, China's 10-year bond yield has slumped to nearly 2.1%, from more than 4.5% a decade ago when its prospects looked much more rosy. And that's why investors always want to make sure that U.S. yields are dropping for the "right" reasons, not the "wrong" ones.  

See you at 1 p.m!

Kelly

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