Tuesday, April 5, 2011

Bonds are worrying about rising inflation

The bond market has a poor record of anticipating major changes in inflation. Treasury yields lagged the rise in inflation throughout most of the 1970s, with the result that real yields were generally low and even negative during the period, and cheap borrowing costs helped fuel inflation fires. Treasury yields also lagged the decline in inflation we experienced in the 80s and 90s, with the result that real yields were generally high during the period, and expensive borrowing costs helped keep inflation low.

But the bond market is not entirely oblivious to what is going on. As the chart above shows, the breakeven inflation rate embodied in 10-yr TIPS and 10-yr Treasuries now stands at almost 2.6% (i.e., the market is priced to the expectation that the CPI will average about 2.6% per year over the next 10 years). That is substantially higher than the 2.0% average breakeven rate that has prevailed since TIPS were first introduced in 1997, and it is only 18 bps shy of its highest level in 2005, just before the CPI recorded a 4.7% year over year gain. Moreover, TIPS 10-yr breakeven spreads have now risen over 250 bps from close to zero at the end of 2008.

All of this adds up to a fairly dramatic statement about how the Fed's quantitative easing program has not only eliminated deflation risk, but now threatens to raise inflation beyond the relatively low levels we have enjoyed for the past three decades.


Benjamin Cole said...

Scott Grannis: This is an interesting chart, but now I have a quibble.

In a recent chart on commodities, you defined the 2000-2011 era as the "easy money era," in contrast with the tight money 1980-2000.

Yet this chart shows TIPS yields going down in the 2000s. Down! And 10-year Treasuries too. Down!

Milton Friedman said low interest rates are a sign of tight money, especially sustained low interest rates. Interest rates have largely trended dwon in the post-2000 era.

Ergo, the 2000s have not been an "easy money" era.

If we have had "easy money" since 2000, where is the inflation and high interest rates?

Somehow, your definitions do not hold water.

Scott Grannis said...

That's a fair point. I would counter by arguing that a) the bond market does not always anticipate the future, and b) monetary policy acts on the economy and the markets with a "long and variable lag," as Milton Friedman taught us. I have noted before that the big drop in interest rates and inflation in late 2008 was the result of an involuntary tightening of monetary policy (the market's demand for money surged as a result of the financial market collapse, and the Fed was slow to respond). Since then, however, the Fed has been generous with its supply of liquidity, and interest rates and inflation expectations are trending higher. This trend will likely become more evident in the years to come.

Benjamin Cole said...

Keep up the great work, and thanks for tolerating a quibble from a layman.
Even when I have a quibble, I always rely on Calafia Beach for my main understanding of the economy and markets.

Public Library said...

The Federal Reserves track record is about as good as the bond or equity markets. Ergo we are in deep trouble in the future...

brodero said...

Respectfully disagree and I believe the concern about QE2 is overblown...Question Don't we need a pick up in wage demands for inflation to take a hold. We have had 11 recessions since 1947 and all of them had a long term unemployed rate ( 27 weeks or longer)to labor force of 1% or lower....we are currently at 4%...
too much slack especially with regard to labor

Scott Grannis said...

Wages are usually the last thing to go up in a rising inflation environment. Inflation is devastating for the average person precisely because his/her wages are always lagging the rise in prices. Inflation is not a wage phenomenon, it's a monetary phenomenon.