When we last left the Treasury market on Friday, the market’s forecast of inflation for the 10 years ahead had fallen at the steepest pace in a year.
As our chart below shows, the inflation outlook slumped to 1.73% on Friday, based on the yield spread between nominal and inflation-indexed 10-year Treasuries. That’s the lowest since early October 2009, and sharply below the previous high of 2.45% set back in late April 2010, according to the government’s interest rate data.
There’s always some doubt about the market’s forecast. Divining the future is a hazardous game, and so the collective bets of the crowd aren’t foolproof. But as the inflation outlook continues to retreat, it’s getting tougher to dismiss the trend as market noise. The solution? Arresting and reversing the rapid decline in the annual pace of the money stock is arguably at the top of the list, as we discussed last week.
Otherwise, economic news will decide the direction of the inflation forecast in the weeks and months ahead. Unfortunately, updates this week are light. Later today comes word of the ISM services industry index. Meanwhile, Thursday’s update of initial jobless claims will provide additional context to last week’s mixed news for the June payrolls report.
If there’s any clarity at the moment, it comes from the labor market. The sure-fire economic solution to the mounting deflationary risk is a strong and sustained rebound in job growth. Unfortunately, the odds look high for a jobless recovery at the moment, thus the market’s outlook for a new round of disinflation, perhaps outright deflation.
Until and if the economic trend intervenes by way of a surprisingly strong burst of growth, the deflationary bias is likely to persist. Not every day, of course. But for two months now, the Treasury market has been telling us to prepare for another round of falling inflation expectations. The good news is that the decline isn’t yet as steep or persistent as it was in late-2008. On the other hand, it’s not yet obvious that a repeat performance will be avoided…unless the Fed comes riding to the rescue by cranking up the money stock. So far, there signs aren’t encouraging.