Earlier this week we pondered the potential for higher deflation in the months ahead. One of the suggestive clues was the falling inflation forecast as implied by the shrinking spread between the yields on the nominal and inflation-indexed 10-year Treasuries. At the time, the market was priced for inflation at 2.13% for the decade ahead (as of May 18). A mere 48 hours later, the market-based forecast dropped sharply: Treasuries yesterday anticipated inflation at 1.89%–the first reading under 2% since last October.
The Treasury market is subject to all the usual imperfections when it comes to implied forecasts and so we should be cautious in reading too much into any one day’s numbers. But this much is clear: the market’s perceived risk of deflation is running higher these days. Given the magnitude of the change, we should think twice before dismissing the message. Indeed, as our chart below shows, there’s been a sharp deterioration in sentiment this month in the market’s inflation outlook. At the end of April, Treasuries expected 10-year inflation on the order of roughly 2.4%, or some 50 basis points higher vs. yesterday’s numbers.
A new round of deflationary risk is unwelcome, of course. Although we’re still a long way from a sustained decline in prices across the board, it’s not too early to consider the hazard anew, as the latest rush into Treasuries suggests. That’s a change for the worse relative to recent history. For six months or so, it looked like the deflation threat had been vanquished. It may yet prove to be so. But there are more than trivial doubts arising today.
Ironically, last month witnessed a long-awaited rise in new business loans. For the first time since October 2008, the monthly tally of commercial & industrial loans approved at commercial banks was higher, according to the Federal Reserve. Although the rise was slight, it was a step in the right direction for thinking that the central bank was finally inducing higher levels of lending again in the corporate sector—a necessary step for thinking that the economic expansion was taking root. Indeed, C&I loans were the last major holdout in the recovery over the past year in terms of showing positive change.
But suddenly there’s a fresh wave of doubt. The apparent catalyst is Greece and the debt woes of Europe. But these concerns aren’t new. In early February, for instance, we observed that the anxiety over debt and deflation was very much in the air. What’s changed? Nothing, really, other than the market has reassessed the red ink challenge and decided the fallout may be worse than previously thought. Pricing risk for the threat du jour is invariably an imperfect science, and one subject to revision. That’s been working to our advantage over the past year; now it’s swinging the other way. Divining the future is a risky business, with the estimates forever in flux.
Meantime, the world awaits more economic data. The numbers that have been supporting the case for growth so far this year are suddenly ancient. The labor market’s apparent return to minting new jobs on a net basis now requires a fresh batch of supporting data to fend off deflationary fears. Ditto for thinking that C&I loans are headed higher. In fact, everything may be reassessed in the days and weeks ahead. What’s needed to stabilize sentiment and convince the crowd that the glass is half full rather than half empty? New numbers that show that the recent signs of economic growth were more than a statistical blip; more than a dead-cat bounce.
It was always the case that the apparent recovery was going to be tested. The massive slump that was the Great Recession was never going to fade away quickly and seamlessly. Instead, the restoration of growth was going to come in fits and starts, and keep everyone guessing at times. Back in January, considering the year ahead, we asked: “Will the economic rebound build a head of steam that’s self sustaining?” Our forecast at the time: “It’s going to a close call.” That still looks like a reasonable prediction at the moment. Wiping away doubts born of the deepest recession since the 1930s was destined to take time. But as mere mortals, we’re all subject to thinking positively when the recent data looks encouraging. We’re not likely to make that mistake again any time soon.
The cause of recovery has taken a hit. It’s not fatal, but it’s not trivial either. For the moment, it’s all about sentiment. And, perhaps, the sentiment is wrong. But for now, it takes a card-carrying contrarian to make the case that the optimism of recent months wasn’t misplaced.
“The risk is skewed towards deflation right now,” Dimitri Delis, fixed income strategist at BMO Capital Markets, warns. Until—and if—we see economic reports to the contrary, risk aversion is the new new thing…again.