Tuesday, May 26, 2009

Bond market to Bernanke: time to take your foot off the accelerator

These charts focus on the market's inflation expectations, which are now almost back to "normal." The first chart is Barclay's calculation of the market's 5-year, 5-year forward inflation expectations, as derived from the difference between TIPS yields and Treasury yields. This is assumed to be the Fed's preferred measure of inflation expectations. The second chart shows the market's expectation for the average inflation rate over the next 10 years. Both charts show how expectations have almost returned to levels that might be considered "normal." The market is now expecting consumer price inflation to average about 2.5% for the foreseeable future.

The message to the Fed is clear: it's time to start taking back all the money that has been injected into the banking system over the past 8 months. Deflation risk has all but vanished. The economy is getting back on its feet (see previous post on consumer confidence). Swap spreads are almost back to normal. Liquidity is returning to the bond market. Equity prices are improving. We've most likely seen the worst of the housing market. The yield on 10-year Treasuries is up to 3.46%, and is closing in on the 4% level which I would consider a good sign that the economy has achieved recovery mode.

Will the Fed get the message? That is absolutely the key question for the months ahead. If they keep the pedal to the metal, their job (keeping inflation low) is going to be much tougher in the future. I think it is likely that they will be slow to react. That means that inflation risk is really coming to the fore.

The gold market has been foreseeing this development for some time; in my estimation, today's $950 gold price assumes that we will have a meaningful increase in inflation in coming years. If gold moves higher, that will be a sign that the market is not only becoming quite confident in a rising inflation future, but also confident that the increase in inflation will be significant.


Tom Burger said...

Shortly after they back away from $2 trillion deficits and all that money creation the apparent economic "progress" will be stopped in its tracks. Without all that largess we'll have big banks and big auto companies failing, at least.

That's why inflationary booms are pointless. Well, worse than pointless, they are damaging to our wealth and well being -- as we saw in the housing boom aftermath.

This "government bailout boom," in my guestimation, will be even more fragile than the credit expansion booms we have come to think of as "conventional."

JMHO. Time will tell.

The Lab-Rat said...

Just to clarify, if you were sole monetary policy man for the US at this precise moment in time you would be doing what exactly right now?

Scott Grannis said...

I would be pushing strongly for the Fed to begin shrinking its balance sheet. There is no longer any need or justification for massively accommodative monetary policy. There are a whole lot of indicators I would base my decision on: gold, commodity prices, credit spreads, TIPS breakeven rates, and the yield curve, to name just a few.

I would spin this in a positive way: the Fed did what was needed at the time to counteract a sudden and massive increase in money demand. Conditions have clearly turned for the better, and so now we (the Fed) are reversing our stance in order to avoid oversupplying the system with money. Fed tightening does not have to be scary, it should boost confidence when policy moves in the appropriate direction.

bitbucket255 said...

On the second graph, what does the "breakeven inflation" curve really mean? Is it the inflation rate above which the TIPS bonds give a higher real return than normal T-bonds?

mrdon said...

It is always easier to propose alternative paths when we don't have the ultimate responsibility for their outcome. But the very least I would recommend to those who are responsible (haha) is that the massive expenditures of all kinds -- stimulus, bailout, whatever -- be carefully targeted. The programs we have now seem to have substantial elements of spending for the sake of spending. This is aggravated by the utter misuse of the word "investment". The people who are spending our money do not seem to understand the difference between a capital expenditure, an accelerated maintenance expenditure and throwing money at the wall in the hopes that some of it sticks.

I surely have reservations about the magnitude of these expenditures and the accompanying debt. It is arguable, though, that genuine "investments" in the things which will ultimately add new value (as opposed to replacing things which would otherwise continue to add value) might, at least, minimize the damage.

Scott Grannis said...

bit: The breakeven inflation rate is essentially as you say: if inflation is higher than the breakeven rate then TIPS deliver a higher total return than comparable maturity Treasuries.

Scott Grannis said...

mrdon: I agree with you. I would argue that the "investments" that Obama proposes to undertake will be much less effective at stimulating growth than the investments that might have been undertaken by the private sector had been allowed to decide how to invest its own money.