Bond Vigilantes and the Risk Premium

Some folks seem to be having a hard time with my previous post, bond vigilantes to the rescue.  They assume that there could be an actual default by the U.S. Treasury Department that would be reflected in a rising risk premium. While this is certainly possible, I find it highly unlikely since the U.S. government could always  print dollars to buy up its debt.  It could gradually "monetize the debt" and allow slightly higher inflation to slowly erode the burden of the national debt as it did after World War II.  This is, in my view, the most likely worst-case scenario, not an outright default.  The real risk for treasury holders then is a higher inflation risk premium, not a higher risk premium. 

But even this outcome seems unlikely in the near term.  The most likely development treasury holders face over the next year or so is a temporary bout of higher-than-expected inflation associated with Fed easing or more rapid economic growth.  This was the premise of my post, not an outright default.  Given my view that a robust recovery has not taken hold because the demand for safe assets remains elevated (i.e. portfolios remain overly weighted to low yielding, liquid assets), a temporary rise in inflation would cause the much needed treasury sell off that would start a recovery.  That is, treasury holders would sell their treasuries and other safe assets and move into riskier, higher yielding assets. We already see this in the relationship between expected inflation (using 10-year treasury breakeven) and stock prices.  The treasury sell off, therefore, would catalyze the rebalancing needed for a strong recovery. 

Note in this story, the risk premium would actually fall with the recovery.  Currently, it is too high as indicated in this post and as suggested by the figure below from Ed Bradford.  The figure shows the S&P500 earnings yield less the 20-year treasury yield.  This equity risk premium spread has been hovering around 5% over the past two years which seems unreasonably high. 

These indicators of inordinately high risk premiums correspond to the ongoing high demand for safe assets. Once the demand for safe assets is normalized--via the portfolio rebalancing--these risk premiums should decline too.