Wednesday, March 14, 2012
2-yr Treasury yields (see chart above) have jumped to their highest level since last summer, as the bond market finally absorbs the emerging reality of a healthier-than-expected economy (or perhaps I should say a less-weak-than-expected economy?). The bond market is now estimating that the Fed will not keep short-term rates at 25 bps for the next two years; Fed funds futures and eurodollar futures contracts now expect one or two "tightenings" before the end of next year. That's still a very modest change in expectations, but it is likely only the beginning. If the economy maintains its recent momentum, the Fed could be forced to begin raising rates before the end of this year, and even that would mean the Fed would be reacting to events reacting than being proactive.
A behind-the-curve Fed is also being priced into the Treasury market, as the spread between 10-yr TIPS and 10-yr Treasuries (the market's expected, long-term inflation rate) has widened from a low of 1.71% last September to today's 2.37% (see chart above). The longer the Fed delays in responding to the new reality of an economy that is no longer fragile and in desperate need of ultra-accommodative monetary policy, the higher inflation expectations are likely to be.
It is with great interest, therefore, that I see that the price of gold has declined by 14% since last September, even as the bond market's inflation expectations have risen. There are several ways of interpreting this. This could be a classic case of "buy the rumor, sell the fact." The gold market has been expecting higher inflation for a very long time, and now that the case for higher inflation is beginning to solidify, prescient gold investors are taking their profits and looking for the next long-term speculation. Or it could reflect the market's realization that since the economy is doing better-than-feared (e.g., Greece defaulted, but the world didn't end), then the case for extreme monetization and hyperinflation has weakened, and thus it no longer makes sense to pay a huge price for a gold hedge. (I note in that regard that over the past century, the average price of gold in today's dollars has been about $500/oz.) I'm inclined towards the latter explanation, because it's still a matter of speculation whether the Fed will in fact end up allowing inflation to rise significantly. In other words, I'm still willing to give the Fed the benefit of the doubt, even as I become more convinced—along with the bond market—that inflation is likely to be higher than expected.
Posted by Scott Grannis at 8:18 AM