by Calculated Risk on 5/29/2009 08:57:00 AM

From Tim Duy's Fed Watch: A Return to a Nasty External Dynamic?

An excerpt:

[W]e are stuck with two apparently contrasting views. On one hand, rising long rates and the related steepening of the yield curve should indicate improving economic conditions - after all, rising yields simply imply that market participants are gaining confidence to put their money to work in more risky endeavors. The steeper yield curve should boost bank earnings and, in time, encourage lending. On the other hand, higher yields may undermine support for the housing market, thus extending the downturn.

And Duy concludes:

I want to believe that the rapid reversal of Treasury yields is a benign, even positive, event. This is likely the Fed's view; consequently, the[y] will hold steady on policy. Challenging this benign view is that the reversal appears to be lock step with a return to dynamics seen in 2007 and 2008 - exceedingly low US rates encouraging Dollar outflows, stepping up the pace of foreign central bank reserve accumulation and putting upward pressure on key commodity prices. I worry that policymakers have forgotten the external dynamic that was hidden by the crisis induced flight to Dollars last fall. Indeed, capital outflows (indicated by a foreign central bank effort to reverse those flows) would signal that much work still needs to be done to curtail US consumption to bring the global economy back into balance. Policymakers are unprepared for this possibility.

A long post well worth reading.