Tuesday, August 2, 2011
Real yields on TIPS of all maturities today reached a new record low. The main cause of lower real yields is falling nominal yields, since the difference between the two (aka expected inflation) has been largely unchanged. Long-term inflation expectations remain "anchored" around 2.5%, although shorter term inflation expectations embedded in TIPS and Treasury pricing point to inflation of around 3%. The main cause of lower nominal yields, in contrast, is the market's concern that the economy is very weak and liable to slip into a double-dip recession, as reflected in the chart below.
Undoubtedly the market remains concerned that the ratings agencies may downgrade Treasury debt in spite of today's accord to raise the debt ceiling. It is more likely, however, that the market is being driven by its Keynesian instincts which say that the big cuts in spending in today's bill will weaken the economy at a time when it is already weak.
I think these concerns are overblown. To begin with, as I outlined in a post last week, there will be no spending cuts at all. The "cuts" contained in the debt accord add up to a very modest reduction in the future growth rate of government spending. If the huge pickup in government spending failed to "stimulate" the economy, then a modest reduction in the growth of spending going forward is very unlikely to kill the economy. By gradually reducing the share of the economy that is managed by the federal government over time, today's bill should result, eventually, in a modest increase in the economy's growth because the private sector will increase its control over the economy's scarce resources and that, in turn, will result in greater efficiency, productivity, and growth.
The other side to the record-low real yield story is that the market remains concerned about inflation. Inflation expectations have not declined materially even as the economy has slowed substantially this year. The record highs that gold continues to post ($1658/oz. as I write this), coupled with a dollar that is very close to its record lows, confirm that inflation fears are alive and well. Rising gold prices also reflect, I think, a market that looks at all the sound and fury that was expended on the debt negotiations, and the paltry sums that were promised to be shaved from future spending hikes, and concludes that Washington is still miles away from where it needs to be to restore fiscal sanity.
In short, the big decline in yields this past week is the sound of deflating confidence in the future, a sentiment expressed in light-hearted fashion in the cartoon below.
Posted by Scott Grannis at 1:00 PM