Wednesday, October 6, 2010

The bond market is bracing for the return of inflation




Lots of important action in the bond market these days. 10-yr Treasury yields have plunged to a mere 2.36%. Recall that they hit a generational low of 2.05% at the end of 2008, when the entire world was terrified of impending economic death and destruction. Are yields today telling us that doom is just around the corner? Absolutely not. This time around things are very, very different.

The plunge in yields today is all about the much-anticipated Quantitative Easing II that is expected to be launched in four weeks, and which could result in the Fed becoming the largest holder of Treasury securities in the world (mostly of maturities 10 years and in). Expectations have been enhanced because the Bank of Japan yesterday announced it would be joining the QE party with bond purchases of its own.

The market apparently figures that Treasury yields inside of 10 years are going to be very low for a very long time. Those who were short Treasuries have thrown in the towel. After all, it costs money to be short, and having to pay out carry for years on a short position is not a very comforting prospect.

The interesting part of the bond market action, however, is in the TIPS market, where yields have plunged by much more than Treasury yields, and in the long end of the Treasury curve, where the spread between 10 and 30-yr Treasuries has widened to its steepest level ever. Since the end of August, when QE2 expectations started to heat up, 10-yr Treasury yields have declined by 10 bps, whereas 10-yr TIPS real yields have dropped by 50 bps. That's a 40 bps increase in annual inflation expectations over the next 10 years. Using the more sensitive measure of inflation expectations—the 5-yr, 5-yr forward breakeven rate—inflation expectations have jumped almost 50 bps since the end of August (see top chart). The spread between 10- and 30-yr Treasuries has shot up to a record-breaking high of 127 bps, up from 105 bps at the end of August.

Note in the second chart above how the drop in Treasury yields in late 2008 reflected deflationary fears (with inflation expected to average zero over the subsequent 10 years), whereas the current drop reflects inflationary fears.

So the market is saying that it has little doubt that the Fed will ramp up its quantitative easing efforts, and almost no doubt that this will prove inflationary in the years to come. The plunging dollar and the soaring price of gold fully support this interpretation.

This is the best evidence you can find that deflation risk has evaporated. The question now is not how low inflation will be, it's how high it will be in the years to come.

As I've been arguing for a long time, when you take deflation risk off the table, you automatically brighten the economic outlook, even though inflation is not typically good for economic growth. I think that explains, in part, why stocks have rallied over 10% since the end of August. The other reason stocks are up is that the prospects for a Republican landslide have improved, and with them, the chances of an extension of the all the Bush tax cuts have risen considerably. Just the idea that Republicans now stand a good chance of "stopping all the bad stuff," as John Boehner recently put it, is reason for cheer considering how gloomy the prospects have been since early last year.

So once again I'm left with this thought: if the prospects for the economy are improving and inflation expectations are rising, why in the world would the Fed proceed with QE2, when it would only complicate things in the long run? This is really important stuff, and I get the feeling that Bernanke & Co. have not yet thought through all the ramifications of what they are planning, nor have they paid sufficient attention to market-based signals.

UPDATE: I'm bringing this up from the comments section since it adds useful info to the post:

The only question now is how high inflation rises. Many worry it's going to rise by an awful lot. I'm not sure yet. Gold has not yet broken new high ground in real terms, and the dollar has not yet set a new all-time low in real terms. So maybe things won't be catastrophic. The Fed certainly doesn't want a catastrophe, and I've learned it never pays to underestimate the Fed's ability to get what it wants. I'm playing this by ear right now.

I note, meanwhile, that real yields on 10-yr TIPS are now at a record low. When you combine that with gold at a record nominal high and the dollar at a record low, you realize that in order to buy protection against lots of inflation you have to pay a pretty stiff price. There is no obvious place to hide.

20 comments:

Bill said...

So, if the Fed wakes up November 3 and reads your blogs on this subject and decides that QE2 is not necessary, does the market crash?

Scott Grannis said...

I don't think so. If the Fed told the world that it had decided QE2 was not necessary given increasing signs of economic health, I would think the world would cheer.

It's common to see people argue that higher yields would snuff out growth, but in reality, higher yields are the natural result of stronger growth. In this environment especially, higher yields would be a direct reflection of a return to economic health. Yes, Treasury yields would probably soar if the Fed called off QE2, but that wouldn't be a bad thing at all for the economy.

brodero said...

Incredible...Bank of America's
10 year was trading at 4.86% on September 30th and today it is trading at 4.58%

Benjamin said...

Ben Bernanke strikes me as extremely circumspect and knowledgable. His speeches and articles are very learned.

If anything, he is too cautious.

If even Bernanke goes to QE2, there is probably is a surfeit of reasons. Bernanke is not one to do anything without lots of solid ground to stand on.

Remember--Milton Friedman called for tight money when we were running double-digit inflation.

Tight money became a conservative cause in that era, and properly so (well, among the Volckerites. The Reaganites got tired of tight money after 1983, and tried to edge Volcker out, and ultimately did).

Today we have near deflation and a sagging economy. Friedman advised Japan to go QE hard and neavy in similar circumstances.

The "conservative" thing to do now is go to QE2, full steam ahead.

If you believe in Friedman and monetarism, that is the way to go.

Public Library said...

Scott,

You seem to nail the recap of what is happening perfectly, but I do not sense any angst in your writing about the consequences of such unprecedented money printing/intervention.

Clearly the market is telling us there is something deadly wrong going on.

It reminds me of tech stocks in '99, housing and oil 2003-2008. We now have skyrocketing easy money signals firing off on all cylinders.

It is naive to think inflation signals such as housing and oil post their collapse will lead the charge which is why they are not. Instead gold, bonds, and other commodities are picking up the slack where other instruments have now cratered.

Not to mention the backdrop of global fragility and all out currency war/QE interventions. I believe this whole experiment is going to end real nasty.

Scott Grannis said...

Public: you make some very good points. As I said in the post, the only question now is how high inflation rises. You're assuming it's going to rise by an awful lot. I'm not sure yet. Gold has not yet broken new high ground in real terms, and the dollar has not yet set a new all-time low in real terms. So maybe things won't be catastrophic. The Fed certainly doesn't want a catastrophe, and I've learned it never pays to underestimate the Fed's ability to get what it wants. I'm playing this by ear right now.

I note, meanwhile, that real yields on 10-yr TIPS are now at a record low. When you combine that with gold at a record nominal high and the dollar at a record low, you realize that in order to buy protection against lots of inflation you have to pay a pretty stiff price. There is no obvious place to hide.

Benjamin said...

Public Library-
Japan went to QE in 200-2006, and it helped their economy. They went back to a delfationary polocy afer that.
They never suffered fom hyper-inflation.

The risks of QE are way overblown. IOdeed, the risk may be we don't do enough QE, or that it doesn't work.

If QE doesn't work, and fiscal stimulus doesn't work, we may have a long slow grind, ala Japan or worse.

The USA ran up a ton of debt. We need to pay it down, and yes, cheaper dollars would help much.

Sometimes life hands leaders a set of so-so options. Whatever you think of Obama, consider his options on Afghanistan. He can spend another $1 trillion and try to "win" (with no assurances), or he can pull out and "lose," or he could go somewhere in-between, and probably "lose."

Sure, long ago we should have not taken on so much debt in the USA.
But here we are now.

Inflating out of it (say, 4 percent CPI or a little more) is one of the better options.

Public Library said...

Scott, you are absolutely right. There is nowhere to hide which is actually my concern.

I do not actually believe we will see hyper-inflation. In my opinion, the system would collapse before the hyper-inflation scenario ever took off.

My concern is when the next instrument collapses (and it will), the shear scale of the fiscal and monetary involvement will drag down many other instruments or economies along with it.

Benj, sorry but I just think you are flat out wrong about how wee need to solidify our economy. Money printing does not provide resources to produce new goods and create jobs. It raises the money price necessary to pay for goods, services, and inputs into production.

Fiddling with the money supply is a fools game. History is clearly proving this theory right.

Public Library said...

"Rates – the price of money – shouldn’t be controlled by the state, up or down, any more than the state should control the price of oil, or bread, or toothpaste.

One of the major reasons the USSR collapsed was an inability to make correct economic calculations, and much of that was due to their arbitrarily fixed interest rates.

One reason why Japan has been fading into the economic background over the last two decades is that the government has artificially suppressed rates, in the vain hope of stimulating the economy."

REW said...
This comment has been removed by the author.
REW said...

Scott, I had the same question as Bill, and I appreciate your answer. However, after reading "Fed Official Issues Call for Aggressive Action" by Jon Hilsenrath in the WSJ yesterday, I am convinced there is no chance the Fed will change course. Jude's old shop put it bluntly: "This inflationist, monetarism is terrible, dangerous witchcraft."
These fools have no idea what they are doing, so there is no hope the will realize the true state of the economy and call off QE2 in the next few weeks.

randy said...

Kenneth Rogoff writing about gold here:



“In my view, the most powerful argument to justify today’s high price of gold is the dramatic emergence of Asia, Latin America, and the Middle East into the global economy. As legions of new consumers gain purchasing power, demand inevitably rises, driving up the price of scarce commodities.

At the same time, emerging-market central banks need to accumulate gold reserves, which they still hold in far lower proportion than do rich-country central banks. With the euro looking less appetizing as a diversification play away from the dollar, gold’s appeal has naturally grown.”

Makes sense to me.

Frozen in the North said...

Scott:

One of your best and most lucid posts. Frankly, with interest rates approaching the zero boundary, taking the inflation punt seems to be a very low cost option with a very attractive asymmetric return.

CFP, EA said...

Scott,

I might quibble with you on one point. You state that people have to pay a very high price for inflation protection, using TIPs yield, the low dollar and gold as proof. While those are all certainly true, I'd argue that many individuals - at least homeowners - have a once-in-a-lifetime opportunity to buy massive inflation protection at a never-seen-before low price: Your mortgage.

The 30-year fixed mortgage hit 4.27%. That's probably about as cheap as it can get. For a person with a mortgage between two and three times income (I wouldn't recommend that ratio going any higher), they get a huge buffer against inflation.

If inflation goes on a tear, their income likely will keep pace if not grow a bit more - the normal increase in living standard over time. But the mortgage stays the same.

For example, suppose a person making $150,000 takes on a $375,000 mortgage (2.5 times income) at 4.25%. His mortgage payment will be ~$22,000 year or 14.7% of his income. Now assume inflation of 7% and wage growth of 8% for seven years. His income has grown to $257,000. But, of course, his mortgage has remained the same. Now, the mortgage amounts to ~8.6% of his income.

Our mortgage-holder has profited quite nicely.

While a bit more complicated, even retirees can benefit due to higher interest rates on their bonds and higher earnings on their stocks.

There's inflation protection out there; it's just not one of the usual suspects.

Also, I might note that with Freddie and Fannie potentially being phased out, we might not have the 30-year fixed mortgage available for too much longer - at least not at these low prices. Without the government insurance, banks either will get rid of the 30-fixed for shorter-term loans or charge a much higher premium for the privilege of locking in an interest rate for such a long period of time.

Thanks.

Scott Grannis said...

CFP: excellent point, and I stand corrected. I've been touting the attractiveness of 30-yr fixed rate mortgages for quite some time, and neglected to mention them again in this post. They are a great way for the layman to place a bet on rising inflation. And I would add that if inflation really heats up, then housing prices are almost certain to rise significantly in coming years, making a leverage bet on housing (via a mortgage) once again a big winner.

Family Man said...

CFP
So, if your idea spreads around we have new real estates bubble:)
Banks should sell it as Anti Inflation Shelter.

CFP, EA said...

Family Man,

You'll notice that I also said that people should keep their mortgage to between two and three times income - 2.0-2.5 if your have other responsibilities such as kids, other dependents or relatively high other debts and 2.5-3.0 if you're fairly unencumbered.

On top of that, obviously, you should have a stable income.

If people followed those rules, we would have never enjoyed the term housing bubble.

The housing bubble was crazy. I've always told my clients that we should expect around inflation, maybe inflation plus one percent (wage growth), as our expected appreciation for housing. It's been that way for hundreds of years. But that rate of return is fine if you have a some leverage.

That's why I integrate real estate (a person's house, maybe REITs)into our investment strategy.

Bonds protect against deflation. Real estate (house, mortgage and REITs) protect against inflation. Stocks protect you from missing the growth in the economy, i.e. they're your portfolio's engine.

Outside of Mad Max, those are the main economic situations that we face. You'll never get creamed - and likely will do quite nicely - if you split your assets evenly between those three categories.

Best.

Daniel said...

Is it possible to get a 150K loan at 4.5% for 30 years without the obligation of buying a "home"? Why wont banks lend the money to people that qualify? why does one have "own" something to get a loan at 4.5%?!?. Rates are so low, I would love a 150k at 4.5% over 30 years. Maybe buy a small investment condo, and pay off debt with the rest.... sorry for the off topic question, but this has been bugging the heck out of me recently...

Scott Grannis said...

Daniel: if you have a home you could refinance or take some equity out and replace it with a small loan.

CFP, EA said...

Daniel,

To answer your question, there are several reasons why banks offer such low interest rates for 30-year fixed mortgages and not for other types of loans not associated with housing.

First, with a house, the bank has some collateral. If your fail to pay back the loan, the bank can sell the house and likely get its money back, especially if you have 20% or more equity in home. Obviously, the banks got away from demanding a reasonable amount of equity before giving out loans, but that's not case today. In addition, the housing market is at or near its low, so banks are pretty safe with 20% equity in the house.

That assurance of return of the loan amount allows for much lower interest rates. Car loans and small business loans are far more risky and thus demand much higher interest rates.

The second reason is Freddie and Fannie. Not only do banks have the ability to get their money back through selling the house, they also can buy very cheap insurance from Freddie and Fannie. That helps hold down rates. (Indeed, that's Freddie and Fannie main purpose.)

Home loans are a special deal for both you and me, and for banks. The 30-year fixed is heaven's gift to the middle class. They just don't know it and, certainly, don't understand how to use it effectively.