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I'm watching the yield curve and TIPS' implied inflation expectations carefully these days. As I've noted several times in the past several weeks, the pronounced steepening of the yield curve at the long end (blue line in this chart) has correlated pretty well with a significant increase in the market's future inflation expectations (red line). Forward-looking inflation expectations have increased from 2% a year at the end of August to almost 3% today. The only time in the past 5 years that we have had a similar-size increase in inflation expectations over a short period was early last year, when the market began to realize that the economy was not falling into a depression/deflation abyss.
The Fed is pulling down Treasury yields out to 10 years, but the Fed has no control over yields beyond that. The increased (and record-setting) spread between 10 and 30 years reflects a market that is balking. The prospect of another round of quantitative easing has convinced the market that inflation is headed higher, much as the Fed now seems to want. Investors are shunning long-term bonds because they are increasingly worried about long-term inflation risks.
This is not good, of course, and that's why the dollar is down since the end of August, and gold is up. Stocks are not getting hit, however, but I think that can be explained if you assume (as I do) that stocks have been depressed for a long time over the risks of a double-dip recession, deflation, and a punishing increase in future tax burdens. The double-dip has so far failed to show up, QE2 all but erases the possibilities of deflation, and the November elections increasingly promise to result in a reduction in government spending and future tax burdens. The combination of all three means that future after-tax cash flows are now expected to be stronger than the market had been thinking. That's why stocks are rallying even though the inflation fundamentals are deteriorating.
UPDATE: Of course, the more inflation expectations rise, the less likely we are to see the Fed proceed with its QE2 program. We've already heard more than one Fed governor say that QE2 is not yet a done deal. I still think there's an outside chance that the Fed does little or nothing in the way of QE2 after next months' FOMC meeting. Though that might be a disappointment to the market at first, any selloff should be viewed as a buying opportunity. It's never a bad thing for the Fed to do the right thing.
16 comments:
You're basically arguing that the market is responding to the Fed committing to do the right thing and squashing falling inflation expectations (as shown on your graph through August) but if the Fed actually fulfills market expectations of what it will do it will be doing a bad thing.
If the market gets disappointed by the Nov. 2 announcement, one can imagine inflation expectations will fall again and that would be a rather bad thing.
I'm saying that the right thing for Fed to do is what the market is expecting it to do. Anything else at this point would have an adverse impact.
Not necessarily. As I've argued in prior posts, the Fed can change expectations just by sounding tough. The more they talk about how they can do a QE2, the less convinced the market becomes about the likelihood of deflation. Fed jawboning can be very effective. They don't have to do a thing as long as they can convince the market that if deflation showed up they will act decisively.
The worst thing would be for the Fed to do QE2 if and when it was not necessary.
Scott,
IMO what you say is true. However JD has a point. The market is expecting an action at its next meeting...in fact, I believe it is already priced in. If there is no action, or if it does not take the form and substance of what is expected, we will likely be in for a selloff.
I suspect that you and I are a bit longer term oriented than some. I would actually welcome a selloff...just not of the '08 variety!
BTW WFC's earnings were quite good. Credit trends continue to improve and they indicated loan demand is slowly picking up.
I do not think Bernanke is going to bet his career on jawboning even if it is the right thing to do. it looks like he would rather treat the nail with the flat end of a hammer.
The US is already blowing new bubbles all over the place. The only question is where and what damage will result when they pop.
Pub,
Emphasis on 'when'. Trends can last a long time..even if they're called bubbles.
John: I think you and I agree. If the Fed does not do QE2 then it's likely we'll have a selloff, and that would be a good buying opportunity. Like Larry Kudlow says today, you need to be ready for the Fed to disappoint, mainly because there is no reason for them to do a QE2 and maybe they will figure this out.
Scott,
Your chart shows a nice correlation since the QE2 idea was floated in August. I see a similar correlation between gold and equities since the August announcement. This gold-equities correlation also took place during QE1. Can you expand your chart in this post to show the QE1 period?
Thanks!
Grannis is entitled to his opinion but not his facts. What matters for possible QE2 is what the FOMC voting members vote.
Now why doesn't Grannis post (link) to those speeches of the FOMC voting members articulating the nuances?
The voting members are: Bernanke,Yellen,Dudley,Bullard,Duke,Hoenig,
Pianalto,Raskin,Rosengren,Tarullo,Warsh
The only voting member who is unequivocally opposed to QE2 is Hoenig.
Scott,
Would you please provide us with an updated chart and commentary on TIPS?
Scott,
Detlev Shlichter touting the virtues of the Austrian school and the coming collapse of fiat money.
I thought you might find this interesting...
http://vimeo.com/15857288
I heard Bernanke's been getting up lately at 2:30 AM to pee instead of his usual 03:00.
You know what tha means.
I don't know if QE2 is necessary or not. I think that determination is above my pay grade. What I do know (at least what I THINK I know) is that Uncle Ben and enough of his contemporaries at the Fed believe inflation is too low. IMO they have made that clear. Furthermore, the market believes them and has discounted some degree of future treasury bond purchases. After the election, we will see what form and degree the QE will take. There is a good chance there will be some disappointment in some quarters, and a selloff in equity prices is likely. However, I think it will be temporary and, ironicly beneficial for further gains late in the year and into 2011.
I think it is a mistake to assume the Fed wil not get what they want. Will they overshoot? They probably will. But we will get higher inflation, higher equity prices, higher real estate prices, higher capacity utilization, and ultimately, higher employment. Perhaps much higher...in ALL of the above. Will it 'destroy' the currency? At the moment I don't believe that is knowable by mortals. Will the currency be worth less relative to gold and other commodities? Almost certainly yes.
Some theorize that 'fiat' currencies are doomed. Well, maybe they are and maybe they are not. There are a lot of variables involved in such sweeping, far reaching prognostications. What I think I know right now is that the Fed wants more inflation and they are going to get it...along with all its consequences. I choose to position my few sheckles to benefit. I'll leave the currency armageddon to the theorists more interested in being right than making money.
Imagine the untapped resources we would unleash if only people did not devote massive chunks of their personal resources protecting themselves from the the damaging effects of money printing.
Think for a minute about a tailor who could focus 100% of his energy on his craft knowing with near certainty he could store the value of his work over time with little effort.
Americans of all shapes and stripes are spending more and more of their precious resources trying to protect themselves from the damaging effects of fiat money printing instead of focusing on their art, craft, passion, and expertise.
It is a sad state when you hand over your money affairs to a body of men with an ability to print money ad infinitum with zero cost. This is exactly what they do and to their benefit only.
Central Banks print money irrespective of its demand. More people should realize exactly what this means. Instead of the people having the power to decide, mon is being placed without concern for its demand. We are simple told it is needed.
This will not last forever. We either engineer a transition or we go through the hell ride to get there.
More evidence that inflation is coming (or here already):
"General Mills, the maker of Cheerios, Chex and Wheaties, will raise cereal prices on Nov. 15. The increase will affect about 25 percent of its cereal production and amount to a “low single-digit” percentage, Kirstie Foster, a company spokeswoman, wrote today in an e-mail.
Prices for some baking mixes are set for “a mid single- digit increase,” effective Jan. 3, Foster wrote. The company’s product lines include Betty Crocker, Bisquick and Pillsbury.
“While General Mills may be the first of the large food companies to really press higher on pricing, we believe many others may follow,” Growe wrote. “It’s just a matter of time, given what is coming down the pike in the way of inflation.”"
http://noir.bloomberg.com/apps/news?pid=newsarchive&sid=aLXlbcsChe74
Inflation is imminent at this point -- hopefully investors are already prepared for this reality...
Inflation has always been with us. You mean more inflation DJM.
This is why our dollars are worth less each and every year and we pay more and more attention to the markets to protect ourselves.
Another wonderful legacy Nixon bestowed upon the people.
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