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.