Monday, October 20, 2014

Reading the bond market tea leaves

Nominal 10-yr Treasury yields have fallen from 2.6% in mid-September to as low as 1.9% last week, followed by a rise to today's 2.2%. The decline mainly reflects a moderation of inflation expectations which in turn are being driven by a 20+% decline in oil prices since June. Real yields on 5-yr TIPS—which I believe closely track the market's real GDP expectations—have gyrated in the past month or so because the bond market has been worried about the "contagion" risk that the U.S. economy faces because of slower growth in the Eurozone and Asian economies, and a "Black Swan" outbreak of Ebola. These fears have subsided of late, mainly because of no new cases of Ebola.

The chart above shows the nominal yield on 5-yr Treasuries and the real yield on 5-yr TIPS, and the difference between the two, which is the bond market's implied inflation expectation for the next five years. The bond market's current expectation for the average change in the CPI over the next five years is 1.6%, which is somewhat lower than the 1.9% long-term average 5-year inflation expectation since TIPS were introduced in 1997. But it's not even close to the deflation expectations that gripped the market towards the end of 2007. Inflation expectations are down because oil prices are down over 20% in the past three months. That has already resulted in a slowing in headline consumer price inflation: the CPI rose at an annualized rate of only 0.6% over the past three months. Meanwhile the core CPI is running just under 2%.

As the bond market sees it, inflation is going to be a little lower in the next few years than it has been in the past few years, thanks to lower energy prices. But over the next 10 years, as the chart above shows, the bond market is expecting the CPI to average 1.9%. That's somewhat lower than the 2.3% annualized rate of CPI inflation over the past 10 years, but it hardly smacks of deflation fears. We've seen levels this many times in the past. Inflation expectations appear to be "well anchored."

The chart above shows the 5-yr, 5-yr forward measure of bond market inflation expectations (i.e., what the market believes inflation will average from 2019 through 2024), which is currently about 2.3%. Note again the absence of anything suggesting deflation. This expectation is fully in line with historical experience.

Putting this all together, we find that the bond market is expecting inflation to be a little below 2% for the next several years, followed by a modest pickup to just over 2% in subsequent years. On average, the bond market sees inflation in the next 10 years being only moderately less than it has been in the past 10 years. There's nothing unusual about any of this.

What is unusual is the bond market's apparent conviction that the massive expansion of the Fed's balance sheet, which has resulted in the creation of $2.7 trillion of excess reserves in the banking system, will not result in any unusual increase in inflation. It's hard to argue with the market, but at the same time it requires a leap of faith of sorts to believe that banks will not want to greatly increase their lending activities to take better advantage of their huge holdings of excess reserves, which currently pay only 0.25% (and by so doing, create an excess of money relative to the demand for it—the classical source of higher inflation). It's theoretically possible for the Fed to increase the interest rate it pays on reserves by enough to keep banks content with holding $2.7 trillion of idle reserves, but we're all in uncharted waters on this subject.

One reason the bond market does not find it difficult to ignore the risk of rising inflation is the chronic weakness of the U.S. economy. This remains by far the weakest recovery ever. Weak growth has been strongly associated with low inflation risk ever since the invention of the Phillips Curve, which postulated that inflation was a by-product of strong resource utilization, particularly labor. High unemployment, a hallmark of recessions and weak economies, was thought to lead to low inflation, and vice versa. The Fed repeats this mantra all the time: the economy is likely to continue to have lots of slack, and that will keep downward pressure on inflation, so they probably won't have to raise rates much for a very long time.

I've preferred to view the absence of inflation as a phenomenon associated with strong risk aversion—not weak growth. Banks—and most everyone in fact— have been extremely risk averse in the current recovery. The demand for money and safe assets like bank reserves has been very strong. Banks have thus been content to accumulate excess reserves, and businesses and consumers have preferred to deleverage rather than leverage up, and banks have taken in mountains of savings deposits. But risk aversion is on the decline, and bank lending is picking up on the margin.

Confidence is picking up, but it is still well below its former peak, as the chart above shows. But if confidence continues to build, then the dynamics of the bond market and inflation could change meaningfully. Banks would feel more comfortable lending, and businesses and consumers more comfortable borrowing. Businesses might feel more comfortable expanding too. All of this would be consistent with a decline in the demand for money and safe assets at the same time as bank lending and the amount of money in the economy increase. That is how we could get to higher inflation: it only takes a return of confidence.

And confidence might turn more positive before too long. Republicans look set to take control of the Senate in a few weeks, according to the latest pricing in the Iowa Electronic Markets. As the chart above shows, the probability that Democrats lose control of the Senate has risen to 92%. It's not unreasonable to think that Congress will attempt to pass more business- and growth-friendly legislation before too long (e.g., lower and flatter tax rates for corporations, scaling back Dodd-Frank, lower marginal tax rates for individuals in exchange for fewer deductions, and market-style reforms to Obamacare). Would Obama want to take a strong stand and veto everything, even as his popularity has collapsed and faced with yet another big electoral defeat for his party? Would Democrats refuse to override his veto considering so many of them these days are trying to distance themselves from his growing list of failures? I doubt it. A friendlier tailwind from Washington would reinforce the trend to rising confidence and could push economic growth up a notch or two.

It could also push inflation higher as well, if the Fed waits too long to ratchet up short-term interest rates. Start worrying if the mood of the country improves and the Fed is slow to react.


Matthew Grech said...

Assuming the GOP takes the Senate... Wouldn't it be a great signal to the nation if the first thing the Congress did was to reduce corporate welfare? It would indicate in no uncertain terms that the GOP is about growth and not about simply reallocating money to their pet supporters. It would announce that things have changed. 'Course, this likely won't happen. They'll probably shovel more money at the Pentagon and accuse any opposition of lacking patriotism. I hope my cynicism is misplaced.

Scott Grannis said...

Fortunately, the Senate is not lacking for people who understand the need to cut corporate welfare and corporate taxes and simplify the tax code. So it's certainly possible we could see some smart moves. But only time will tell of course.

David Spiegler said...

You are using the wrong chart. D-lose means 49 or fewer democrats. It really means 51 because 2 independents caucus with the them. There is another chart rh_rs which is at 83.

Benjamin Cole said...

"The bond market's current expectation for the average change in the CPI over the next five years is 1.6%"--Scott Grannis.

Excellent blogging as always, btw.

Okay, here is one problem: Nearly all economy-watchers concur a central bank should do what it says it is going to do, and be predictable, and have credibility.

Okay, the Fed said its target is 2% inflation on the PCE. That runs about 0.5% lower than than the CPI. In other words, the Fed said its target is roughly 2.5% on the CPI.

Instead we are at 1.6% on the CPI, and trend is still down.

So, I have no idea is the Fed means what it says. Maybe 4% inflation will be fine too. Maybe no one is control at the Fed.

As for optimism regarding new policies in the GOP takeover of the Senate: Well, we saw the GOP in action 2000-2006, when they owned the whole DC-town, Senate, House, White House, Supremes. Huge expansion of government, big deficits, a return to the "deficits don't matter" mantra. Medicare Part D, explosion of rural welfare, as national security apparatus double the size of when we faced a true opponent, the Soviet Union.

I have lost faith in either party, and wish a Ross Perot or someone could have won and upset the gravy-train somewhere along the line.

I sometimes think we have a choice between the socialists (Donks) or the national socialists ('Phants).

A Hobson's choice.

steve said...

when you speak of "the bond market" you obviously mean treasuries but I've been an active and successful bond market trader for 20 years and treasuries are the WORST security to trade. the price of treasuries reflects not only inflation expectations but also FEAR and the recent move (I would argue a capitulation) to under 2% for literally a moment was obviously NOT due to inflation but rather a confluence of "fear factors" not the least of which was the media driven overreaction to ebola. I'm having a great year in HY munis and I believe right now presents another opportunity to get into HY corps. 6%+ yields while treasuries and are at 2.2% and very low (practically 0) default rates. color me bullish.

Hans said...
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Hans said...

Very interesting read, Mr Grannis.

Steve, excellent comments and I agree with your premise.

The national governmental unit, badly needs controlled inflation and Treasury rates, to avoid a blow up in the budget.

Despite the decline in federal deficit, overall debt continues to grow will represent a real problem down-the-road.

RK said...

To say there has not been a new Ebola case is a bit insensitive. I know your focus in the US markets but still we can be a bit respectful of the suffering African countries. In fact the opposite happened last week. WHO said the number of cases in Africa has gone past 10,000 and Mali reported its first case. The Ebola fire rages on.