Monday, July 18, 2011

Bond market sees very weak growth & higher inflation


The yield on 2-yr Treasuries is once again at rock-bottom levels (0.36%). This yield is a window to the market's expectations for Fed policy, since it can be equated to the expected average Fed funds rate over the next two years. With Fed funds currently at a mere 0.1%, the market obviously doesn't expect much in the way of Fed tightening over the next two years. Those expectations, in turn, flow directly from the market's collective belief that the economy is going to be dreadfully weak for a long time, thus forcing the Fed to remain ultra-accommodative. Weak growth and low yields, in other words, go hand in hand; as the above chart illustrates.



Many observers argue that the extremely low level of short-term Treasury yields is also a sign that the market expects very low inflation or deflation, but the chart below shows that in fact just the opposite is true. The bond market's inflation expectations have been on the rise, as reflected in a steeper slope between 10- and 30-yr Treasuries, and a rise in the 5-yr, 5-yr forward expected inflation rate that is embedded in Treasury and TIPS prices.


The message of the bond market also illustrates the policy conundrum that confronts the Fed: despite the most accommodative monetary policy ever, the economy is refusing to respond. The knee-jerk reaction of bureaucrats and politicians is to apply yet more stimulus when stimulus fails to work, but we've now had several years of super-accommodative monetary policy and massive fiscal spending stimulus, to no apparent effect. All we have to show for this exercise in public sector hubris is rising inflation expectations and moribund growth expectations. Which is not surprising to me, since as a supply-sider I have always thought that growth can only come from hard work, investment, and entrepreneurial risk-taking. The proper role of government is not to direct the economy's efforts, but to provide for essential services, uphold the rule of law, protect private property, and protect the purchasing power of the currency, among other (limited) things.

So the right thing to do is not to do more of the same, but to reverse course. Tighter monetary policy would reduce inflation expectations, strengthen the dollar, punish the gold and commodity speculators, and restore investors' confidence. Reduced government spending would free up resources for the private sector to exploit and increase investment, since it would automatically reduce future expected tax burdens—and increase the expected after-tax return to risk-taking. 

The bond market is trying hard to send its message to Washington. Is anyone listening?

9 comments:

Patrick T. said...

As a Canadian investor fully invested in US equities (non-commodities related that is), I couldn't agree more with your conclusion...

Benjamin said...

Not sure the Fed is being all that accommodative. Sweden's Fed-equivalent marshalled a larger QE program, and met with success.

The Fed cannot be "stimulative" through interest rates when it hits the zero bound. It has to go the QE, but more aggressively than it has. See John Taylor's papers on Japan, as well as those of Bernanke and Milton Friedman.

The Fed may appear to be accommmodative, but that is because a capital glut is pushing down interest rates.

As for inflation, the core CPI is running at 1.6 percent for last 12 months. That is below target.

When the economy is at 10 percent unused capacity, and nine percent unemployment, and inflation is running at 1.6 percent, I can't see how the Fed can stand by and do nothing.

I do not agree with a do-nothing policy at this juncture.

I concur that federal deficit spending needs to be curtailed, but the Fed needs to embrace QE and some other measures.

William said...

Patrick T. - with your "fully invested in US equities" position how do you like the rising Canadian loony? Personally, I own Canadian and Australian natural resource stocks including ANZBY, BHP, CNQ, CVE, ECA, NABZY, NXY,POT, RIO and TLM. I only wish that I owned more Australian, Canadian and Swiss equities because of their strong currencies vis a vis the US Dollar.

Dr William J McKibbin said...

The bond markets foretell the future -- the US is likely to suffer an economic shock in the near future (a US and/or California default come to mind -- a default across the European southern flank is also a candidate) that will dramatically change the monetary and fiscal situation overnight -- QEIII of $3-5 trillion over the next several years will follow soon thereafter -- an income tax holiday for wage earners earning less than $250,000 annually is also likely -- however, a horrific depression is likely to decend upon America before the end of the year or early next year -- government employees at all levels are likely to be standing in soup kitchen lines across America -- beware of government bonds, but invest defensively into dividend paying stocks and rent paying real estate -- I am not a precious metals advocate, but if you already hold some gold/silver, then retain those holdings until interest rates begin to rise -- note that gold hit $1,600/oz today -- hard times are coming and I am not kidding when I urge Americans to take care of their own as events unfold...

PS: I am tracking corporate paper interest rates, which are starting to rise -- high quality commercial paper could become very attractive should rates approach 10% -- keep an eye on interest rates in AAA and asset-backed commercial paper should interest rates begin to rise...

Bonanza959 said...

without question, federal actions have heavily influenced our challenge to get jobs opening, etc. But I also wonder if the role of hugely increasing productivity of much of the new technology developed and employed over the last 10 years is also allowing employers not to hire. What do you think?

Patrick T. said...

@William I surely don't like the rising loony against the USD. However, my stocks are doing way better than the CAD/USD trade. One thing I find funny is that 15 years ago, nobody wanted to touch Canada. Today, Canada is in every portfolios. The average house price here nationwide is $372K. CANADA HAS IT'S HOUSING BUBBLE. People buy houses with no equity and the mortgages are backed by the government. Sooner or later, this thing is going to blow-up as it did in the US and Europe. Canadian are ultra leveraged, more than the Americans were at the peak of the housing bubble, but no one cares. What happens when everybody is on the same side of the trade? Yes, a lot of speculators will get burned on Canada and 15 years from now, nobody will want to touch it again. In the meantime, you can buy the best companies in the world, trading at historically low p/e ratios, and all of this with an overvalued CAD (for a Canadian that is) Good luck!

John said...

"an income tax holiday for wage earners earning less than $250,000 annually is also likely"

God, I hope not. Fiscal responsibility inspires confidence. No new tax cuts. Politically, once they're cut, we can't bring seem to bring them back.

Unknown said...

Scott,

Thank you for your summarizing words (...since as a supply sider..., and The proper role of government is not...).

I often use your words when talking to my innumerate friends who don't understand what is going on in the economy.

These friends are starting to listen.

Tennesee Moultansanti said...

Any comment on the major move in the long bond today?

might not continue but that 10-30 spread will continue to tighten with lower growth expectations.