The bond market is watching Illinois carefully

One of the interesting stories we will see play out this year is what will happen in states that are heavily indebted and have made little to no progress toward balancing their budgets.  Exhibit A in today's WSJ is Illinois, which has issued debt to pay current operating expenses (always with a promise to come up with a better solution next year, and the year after, and the year after that).  Illinois 10-year bonds are priced a full two percentage points above the broader state-local bond market. 

What's a bond buyer to do?  The two extra points look attractive, but maybe the spread will widen.  If the state does not get its budget in order, what is the default risk?  Would Bernanke and Geithner swoop in and save Illinois with federal dollars?  The state is considering raising its personal income tax from 3 to 5.25% as part of its budget deliberations. 

How is that QE2 thing working out for you?

Fed announces aggressive plan to buy long term bonds to lower long term interest rates and stimulate the economy.  Contrary to expectations, fears of inflation lead to slightly higher long term interest rates.  Don't pull on Superman's cape and don't mess with the bond market.

Bond buyers think inflation will rise

Yesterday the U.S. Treasury sold a five-year $100 bond for $105.50.  Are people knowingly paying the feds to borrow money from them?  No, markets have not gone completely insane.  Today's NYT reports that these are TIPS (Treasury Inflation-Protected Securities) bonds, which guarantee that the principal will not be eroded by inflation.  This is done by indexing the $100 to the Consumer Price Index.  Compared to the yield on regular bonds, the market is in effect signaling that it expects inflation to rise over the next five years and is willing to pay a premium to hedge against that risk. 


NYT also reports fears that the Russian drought and extreme weather in the U.S. corn belt will shift food prices upward over the next few months.  With the Fed expected to buy more long-term bonds in the coming months, are we looking at a replay of the 1970s with high inflation AND high unemployment?