May 29, 2008
BOND MARKET BLUES
Reports of rising inflation are everywhere, and the bond market is paying attention.
As evidence, we turn to Exhibit A--the 10-year Treasury yield, which closed above 4% for the first time since December 31, 2007. Rising yields are present in other maturities, too, including the 2-year Note, which yesterday settled at 2.62%, the highest since this past January.
It's not hard to guess what's behind the pop in yields: inflation fears, the bond market's worst enemy. Securities with fixed coupon payments are the first to suffer in a world of higher inflation.
As The Economist points out this week, inflation is bubbling around the world, particularly in the emerging market countries. What does that mean for U.S., Europe and the rest of the developed world? Food, energy and raw materials prices will "remain high," the magazine predicts: "In other words this is a permanent relative-price shock, not a temporary one. Yet this does not mean that commodity prices will keep rising at their current pace. Higher prices will encourage increased supply. And even if prices remain at today's levels, the 12-month rate of increase will decline, helping to ease global inflation."
Yet worries of higher inflation in the mature economies are still tempered by the widespread belief that the slowdown in the U.S., Europe and perhaps in some developing nations will take the edge off inflationary momentum. Perhaps, but the bond market seems inclined to price in a safety cushion for yields, just in case.
Staying cautious certainly has some appeal these days. In Europe, higher-than-expected growth in money supply is stoking fears that inflation is headed higher on the Continent. "With the underlying pace of monetary growth still strong, the latest data will do nothing to ease the ECB's inflation concerns," Capital Economics economists Jenifer McKeown and Ben May said via AFP.
As for the U.S., Dallas Federal Reserve President Richard Fisher counsels that the central bank should begin raising rates if inflation expectations take wing. "If inflationary developments and, more important, inflation expectations continue to worsen, I would expect a change of course in monetary policy to occur sooner rather than later, even in the face of an anemic'' economy, Fisher said yesterday, according to Bloomberg News.
By some accounts, inflation expectations in the U.S. are already worrisome. The folks at Guild Investment Management in Los Angeles, for example, opine in a commentary from Monday that the warning signs are flashing. Noting that a CNBC anchor was recently questioning the U.S. government's official inflation numbers, Monty Guild & Tony Danaher responded: "I don’t usually listen to financial TV, but it is important to note that when a medium like financial TV (which is slow to catch on to new trends) begins making fun of the government’s inflation reports…it means the public at large is waking up. They are waking up to the obvious fact that inflation is here and it is a lot higher than the government admits."
At the same time, the market's inflation expectations still look fairly tame. The spread between the nominal 10-year Treasury and its inflation-indexed counterpart has been in the mid-2% range for much of this year, and it remains there--2.45%--as of last night's close. The implication: the outlook for inflation is 2.45%.
Mr. Market reserves the right to change his view, of course. In fact, one could argue that such a change is underway as we speak.
Posted by jp at May 29, 2008 9:48 AM
"the market's inflation expectations still look fairly tame."
I wonder if that will change with Dow raising prices 20%?
Posted by: me at May 29, 2008 2:01 PM