Wednesday, December 14, 2011
The bond market is out of whack, because bond yields are not consistent with the inflation expectations embedded in bond prices.
The top chart compares yields on 10-yr Treasuries to the year over year changes in the Core CPI. Normally, the two should move at least in the same direction, and at approximately the same level, since over time the rate of inflation is the major determinant of bond yields. Instead, they have moved sharply in opposite directions over the past 6 months or so. Ok, you say, but maybe the decline in bond yields is simply the market saying that inflation will be much lower in the years to come?
If that were the case, then the second chart would look very different. As it is, it plots the market's 5-yr, 5-yr forward expected annual rate of inflation, based on the relative prices of 5- and 10-yr TIPS and Treasuries. This is the sensitive, forward-looking measure of inflation expectations that the Fed considers to be the most important and most reliable. Inflation expectations by this measure are about where they've been for the past 10 years (between 2 and 2.5%), so there's nothing unusual here. And if you consider the third chart, which compares 10-yr Treasuries to 10-yr TIPS, the message is the same: inflation expectations are nothing out of the ordinary, and very much in line with what we have seen over the past decade.
So the problem is that the current level of 10-yr bond yields is priced as if inflation were headed to zero, when a broader look at the TIPS and Treasury market reveals that inflation expectations are somewhere in the neighborhood of 2-2.5%.
The only reasonable explanation for this divergence, as far as I can tell, is that the level of Treasury yields is artificially depressed. TIPS and Treasuries of similar maturities, when taken together, are priced to normal inflation expectations, but in isolation their yields are too low to be consistent with their implied inflation expectations.
This is a highly unusual circumstance that can only have highly unusual roots. I think those roots are most likely to be found in the Eurozone. Such is the fear that the PIIGS defaults will destroy the Eurozone banking system and ultimately lead to a global depression and a financial market collapse, that investors are willing to pay exorbitant prices for Treasuries in view of their safe-haven status. The risk-free status of Treasuries seems paramount, far more important than possible concerns about inflation.
If there is a message here for investors, it's that fear has reached extraordinary levels, artificially inflating the prices of Treasuries. And it's not a stretch to go from that conclusion to the belief that fear is also artificially depressing the prices of equities.
Current prices can hold only if we really are on the cusp of a major collapse. To be bearish you have to believe that the collapse will be unlike anything we have ever seen before, or maybe even worse.
Posted by Scott Grannis at 2:56 PM