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Widening Term Spreads Would Be Good News

Paul Krugman will be pleased, not distressed, by further widening of the U.S. term structure:

A Note On The Term Spread: [T]o a first approximation you can think of the long term rate as reflecting an average of expected future short-term rates. Short-term rates, in turn, tend to reflect the state of the economy: if the economy improves, the Fed will raise short-term rates.... If the economy improves, short rates will rise; but if it worsens, well, they’re already zero, so there’s nowhere to go but up. This implies that there has to be a positive term spread. Now, this spread could be fairly small if people expected the economy to remain in the dumps for a long time; see Japan. What the large spread now tells us is that the US economy is in the dumps now, but that investors see a reasonably good chance of a strong recovery in the not-too-distant future. That’s good news, not bad news....

[I]f investors were growing worried about US ability to honor its debts, they would be worrying about a breakout of inflation as well as or instead of default per se. But we can track that by comparing interest rates on ordinary bonds and inflation-protected bonds. What we see is that from 3/17 to 3/30 — the period that inspired all those recent scare stories — the nominal interest rate on 10-year bonds rose by 26 basis points; the real rate rose by 28 basis points. So expected inflation actually declined, marginally. This is not at all what you’d expect to see if markets were pricing in fears about the US ability to repay. It is, on the other hand, exactly what you’d expect to see if markets slightly upgraded their hopes of recovery.... [A]ll that huge spread is telling us is that we’re up against the zero lower bound, but that markets think we may not stay there.

Once again, the two rules:

  1. Paul Krugman is right.
  2. If you think Paul Krugman is wrong, refer to rule #1.