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Bond Markets Rediscover Inflation....

publication date: May 22, 2009
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The biggest change in markets this year, and one generally overlooked, has been the disappearance of deflation risk. At the March equity market lows, the year-over-year difference in the 12 month percentage return between stocks and bonds hit a historic milestone not seen in over seven decades.  The return on stocks became so oversold relative to bonds that the degree of difference hit three standard deviations from the historical average (a very strong contrary signal, just as oil moving 3 SDs from its long-term average was a great sell signal last year). It could be argued that such market extremes may mark a major turning point in asset leadership after a 25 year secular bond bull market. The chart below shows how market expectations of future inflation have risen. (Inflation expectations are calculated by subtracting the real yield on TIPS from the nominal yield on Treasuries of similar maturity; generally 10 years are used.)

At the end of last year the bond market was expecting to see roughly five years of deflation, followed by 5 years of modest inflation, adding up to almost a zero net change in the price level over the subsequent 10 years. Just five months later, the bond market now expects inflation to average about 1.1% a year for the next 5 years, and 1.7% a year for the next 10 years. While this marks a pretty dramatic shift in expectations, the inflation discounted by bond prices today is still lower than it has been for the past 5 years, and lower than the inflation registered in any 10-year period since 1965. Recent comments by leading economists that the US needs to manufacture 6% or so CPI inflation to erode in real terms its massive debt burden suggests that inflation risks are increasingly to the upside.


Rising inflation expectations are also evident in the steepening of the yield curve. Despite the Fed's promise to buy up to $300 billion of Treasury bonds, T-bond yields have risen steadily this year even as short-term rates have hovered near zero. A rational investor would fully expect significant Fed purchases of T-bonds to result in higher bond yields, since those same purchases would increase the risk of higher inflation (i.e., debt monetization is a direct source of inflation). Having been extremely cheap, TIPS are now about fair value in terms of real yields.
I would not expect to see real yields decline much further, even if inflation expectations continued to rise, because I think that higher inflation expectations will be expressed primarily in rising nominal yields on Treasuries. Broadly, the buyer of TIPS should not expect to see their price rise by very much, if at all; the benefits to owning TIPS will be realized primarily by a rising income stream if inflation proves to be higher than the market now expects because of the CPI indexation.

A return to higher inflation is already being refected in commodity market speculation and would undermine the investment needed to produce higher productivity. The recent weakness in the dollar and the renewed upturn in gold prices, coupled with ongoing gains in commodity prices and a steeper yield curve are all portents of rising inflation pressures. Whether the Fed acts in a timely fashion to offset these pressures is going to be very important to how strong the recovery is going to be. I suspect that, fearful of repeating the Japanese experience, the Fed stays too easy for too long we will see a return of asset price bubbles and a recovery will be capped at 2% real GDP growth at best. Alternatively, rising long bond yields and a struggling dollar may force the Fed's hand, and force a premature rise in rates to restore investor confidence, risking a renewed downturn given the sensitivity of a hugely leveraged economy to even marginal rises in the cost of money. The sudden reversal in deflation fears has been a huge positive for risk assets like equities and commodities in recent months, but the inflation risk inherent in the huge monetary stimulus being applied globally may yet create offsetting instability in the bond and currency markets.