Monday, August 16, 2010

Bond yields and inflation

The 10-yr Treasury yield has fallen to a new post-2008 recession low of 2.58%. Yields have been lower, but only by a bit, and only in the late 1930s and 40s, which were times of profound concern about the future of economic growth. I take this as prima facie evidence that market is priced for some very, very bad news. Pessimism can hardly get much deeper than it is today. I reproduce the history of the CPI over this same period below:

Note that the late 30s and most of the 40s were times of very high and volatile inflation, yet 10-yr Treasury yields were a mere 2-2.5%. If this is not a great example of how low bond yields are not a reliable indicator of impending deflation, I don't what is. Indeed, if history is a guide, very low bond yields such as we have today have more reliably been a sign of very high inflation (note how bond yields were relatively low in 1975, when inflation spiked to double-digits.

As with my post yesterday, I am not claiming that low yields are proof-positive that inflation is set to rise. Rather, I think it's important to note that the history of very low bond yields offers little or no comfort to those who are betting that deflation is more likely than reflation going forward.


Benjamin Cole said...
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Benjamin Cole said...

And those T-bond yields keep sinking despite China now being a seller, not a buyer. And China has been (until recently) our biggest creditor.
This is fascinating--and I think underlines what I have been saying. Capital is rife, abundant, everywhere.
Those of you wanting safety in savings will have to be prepared to pay for it. Literally. Expect small negative real yields on Uncle Sam IOUs.
I see deflation ahead. The Fed is still fighting the last war, the one on inflation.
We also need to eliminate taxes on dividends and capital gains, and phase out the homeowner mortgage interest tax deduction. I would increase sharply gasoline taxes.
Those are my views as of this afternoon. I reserve the right to change them after I read John's post.

Mr. Kowalski said...

On a positive note {for those who are current on their bills, employed and not under water} we'll soon be at 3.5% mortgage rates.. I myself am thinking of refinancing my 5.5% deal..

Benjamin: I agree with your deflation analysis.. not in all asset classes (grains and gas in particular should hold up well) but with so little credit available to both consumers and businesses our consumption based economy is slowly being constricted. If I were an investor, I'd seriously consider a short S&P ETF at this point and timidly try a long USD ETF.

As for government, reducing cap-gains taxes would be a terrific start, but when do we get to the partt where we spend & borrow less ? The Chinese becoming bond sellers should be a warning shot across the bow, but I doubt anyone in DC will hear the cannonball whizzing by.

As negative as I am in the short run, in time I think America will be just fine.. we as a people are an industrious and clever lot. But the more I think about it, the more I find myself in agreement with Krugman and his "Long Depression" article. {Here I must say that pretty much everything else he says is crap}

Benjamin Cole said...

Mr. Kowalski:
Making predictions is hard, especially about the future.

I change my mind every day about the US outlook, usually depending on the last article I read.

The pessimists are usually wrong, but dang we have run up debts.
When I propose inflation now (five percent for five years), I recognize it as a quick fix, with the real fix being more investment, less debt and balanced federal budget.

Speaking of Krugman, he also today calls for us to get tough on China trade. The old hound-dog Krugman may bay at the moon, but every once in while he barks at a real fox too.

Daniel said...

I've been seeing many signs of deflation around the LA area. There are so many 'for rent' signs everywhere. And I'm not even exaggerating this at all. A condo that was renting for $1800 2 years ago is barely going for $1400 today. Thats a 22% drop in rental prices. Just an everyday observation in "the real world"....

John said...

I usually find myself skeptical of Marc Faber headline quotes for reasons I have previously mentioned but he is quoted this AM saying investors should avoid US Treasury securities. This is consistent with Bill Gross reducing his treasury exposure (per Bloomberg) and the Chinese (very slightly) reducing their holdings. I can see no value in a ten year treasury under 3%. Faber says this is all going to result in inflation, not deflation. I find myself decidedly leaning in that direction.

BHP has offered to buy Potash of Saskachewan (POT) for $130 per share, a ~20% premium to today's price. The company has (correctly, IMO) rejected the offer as inadequate (too low). BHP clearly does not see global deflation or they would not be bidding for POT. This is likely the opening gambit for this nearly irreplaceable supplier of fertilizers. The world needs food and you can't get very much from an acre of land without fertilizer.

Scott Grannis said...

Daniel and others: Observing that some prices are falling is not equivalent to saying we are in a defaltionary period. Deflation is when all prices fall. What we are seeing these days are relative price changes. Some prices are falling, particularly for those things that were built to excess like real estate, while some prices are rising (e.g., copper, gold, and foreign currencies). This in fact something that happens all the time, as the market sends signals to asset owners and producers that it no longer wants, or wants more of, what they have to offer.

Doug MacGibbon said...

Scott, Looking at the inflation (CPI)chart from about 1982 to the present in the context of trying to maintain a stable currency in the face of a reckless fiscal record over most of that period - the value of the dollar seems to have remained remarkably stable over a 28 year period, in spite of all of the second guessing we all do of Fed policies.

A subsequent chart (History of the Dollar posted 8/18/2010) shows the value of the dollar back to 1973 with wide swings, but that is also charting the flip side of the fluctuating value of the world's other currencies. - Doug

Scott Grannis said...

Doug: I'm not sure I would agree with your choice of adjectives. While the CPI inflation rate has been relatively low and relatively stable since 1982, the same can not be said for the value of the dollar, which has dropped precipitously relative to goods and services. The CPI index has risen 130% since 1982, which implies that the dollar lost 56% of its value during that period.

I'm not ready to say that the Fed's ability to keep inflation (year over year) within a range of -2.1% and +6.3% from 1983 on, with the dollar losing over half of its value, constitutes a remarkable achievement on the part of the Fed.