I’m in a bit of a wonkish mood today. Last week bond yields have risen to the highest levels in about a year, thus making market participants nervous, thinking “is this it?”. Some in the “inflation is bad and imminent” camp are probably ready to pop Champaign bottles open to celebrate the long (very long indeed) awaited arrival of inflation and a vindication of their self-imposed black-and-white view of the world. But let’s examine two obvious questions: 1. Is inflation indeed already here? and 2. Is it as bad as they say?

First, the whole purpose of the much-derided Bernanke’s QE exercise is to spur growth: that’s what the Fed does when the economy is slow – cuts and keeps the interests rate as low as possible for as long as the economy is weak. The widely used indicator that the growth is back is inflation: if we begin to spot rising prices it means the economy is recovering (people find employment, consumers back in the stores, driving prices up). This is a far cry from Zimbabwe or Weimar Republic hyperinflation which is what alarmists have in mind when they say “inflation”.

Second, and this is an extension of the previous point – inflation is not always bad, precisely because it indicates a growing economy. It’s all about the range: 2% inflation is too low, Bernanke and his Fed colleagues would probably like to see it in the 4-5% range, 7-8% would probably warrant a tightening action from the Fed (rising rates, this is what Paul Volcker famously did in the early 80s). Yes, the Fed wants to see real, consumer-driven inflation rising, which of course doesn’t mean it wants to see it rising forever. Fed’s actions at keeping interest rates low are intended for a pick-up in business activity (making it cheap to borrow and consume or start a business), thus inflation is not seen as a negative side-effect that everyone should fear, but instead an intended and positive consequence of QE.

This is where many people get confused: Bernanke is pushing down rates in order to see them rise? In a sense, yes. Here’s a good summary:

“In a nutshell, that’s the QE conundrum. Central banks argue that their bond purchases are meant to push down yields in order to make long term finance cheaper. But, at the same time, a sign that QE’s working is rising yields.”

10-year Treasury yields have risen to 2.25% recently, highest in a year, which many say is some kind of dangerous threshold. Bond traders are especially jittery and here’s why (now I’ll get really wonkish, but if you do read on I promise to make it exciting if you remember one thing: when bond prices rise, interest rates decrease; and vice versa, if bond prices fall the interest rates rise): Many of the bond portfolio managers are holding huge portfolios of agency mortgages. Those mortgages are primarily fixed-rate – they pay a fixed coupon. If interest rates rise, like they did in the past few weeks, it means that homeowners holding those mortgages suddenly pay a lesser (in relative terms) interest rates than the market and thus are less likely to refinance. Because those people are less likely to refinance, our bond managers are stuck with their portfolios of mortgages that pay less than they could get in the market today. On top of that, because people are not refinancing, it forces bond managers to hold those losing bonds longer (it’s what they call duration risk), and because the average maturities of those bonds are further into the future it also increases those bonds’ risks and volatility (one would much prefer to hold a 5-year bond as opposed to 10-year bond all other things being equal – you get your money back faster). So now, our bond managers who thought they were holding a 5-year bond find themselves holding a much “longer” bond that is risker and thus requires additional hedging. Now we come to this concept that they call “convexity vortex”. In order to hedge their exposure to rising interest rates the bond managers’ most widely used tool is to sell US Treasuries: because they’re losing money on their portfolios of mortgages due to rising rates, they want to at least make money on the other side of the trade – be short Treasuries and thus benefit from rising rates on this hedge. So as interest rates increase they begin to sell more and more US Treasuries to hedge their portfolios. This brings a self-perpetuating vicious circle: rates rise and makes them put on hedges by selling Treasuries that, in turn, make Treasury rates rise even higher.

But no matter how important bond traders fancy themselves to be (Master of the Universe, Bond Vigilantes), the real danger at this moment is not rising interest rates, but the premature slowing down of the QE. The state of the economy is much more important than the hurt feelings and reduced fees that will plague bond managers. Besides, according to Krugman, it’s hard to imagine scenario where these high bond valuations don’t take some kind of a haircut. Just look at this curious matrix that he put together:

It’s all about one’s perception of the economy: inflation hawks see inflation creeping on and will pick scenario 1; those who think Bernanke is on the verge of snatching the QE punch bowl will pick scenario 2; and those who see a recovery, but still subject to continued QE (I’m in this camp), will pick scenario 3.

I pray to monetary Gods that Bernanke is in my camp too.