Monday, November 1, 2010
This chart is a good way to track how the bond market's inflation expectations are being driven by the prospect of another round of quantitative easing (QE2).
The blue line is the slope of the yield curve from 10 to 30 years. Since late August, when talk of QE2 began heating up, the long end of the yield curve has steepened dramatically and to new all-time highs. That is a direct reflection of the fact that bond investors are getting nervous about the long-term prospects for inflation. The Fed may be able to keep 10-yr yields from rising with massive bond purchases and promises to keep the funds rate near zero for a long time, but the Fed has little or no ability to distort 30-yr Treasury yields. The curve is steepening because investors are shunning long-term bonds.
At the same time, the 5-yr, 5-yr forward breakeven inflation rate shown in red (which the Fed has said is its favorite measure of inflation expectations, and which is more sensitive to changing expectations that the spread between 10-yr Treasury yields and 10-yr TIPS yields) has surged from 1.92% in late August to 3.07% today. If we throw out the blip in early August, this measure of inflation expectations is higher than it has been at any time since TIPS were first launched in 1997. This is a fairly dramatic statement on behalf of the bond market, which until recently has been very reluctant to entertain any fears that the Fed may have gone too far in its efforts to stimulate the economy.
Will no one at the FOMC meeting tomorrow and Wednesday have the courage to stand up and argue against QE2? There is no shortage of evidence to support the case that QE2 is not only unnecessary but also foolish. High on the list would be 1) today's much-stronger-than expected ISM manufacturing report, 2) rising inflation expectations, 3) $1350 gold, 4) a very weak dollar, and 5) soaring commodity prices. There is no sign of a double-dip recession, no evidence of deflation, plenty of rising prices, no signs of any liquidity shortage, and lots of evidence that the Fed's actions to date have resulted in an over-supply of dollars to the world.
Posted by Scott Grannis at 12:24 PM