The Calm Before The Storm?

The Treasury market’s inflation forecast has been a reliable barometer of the ebb and flow of crisis and recovery in recent years. In July and August of 2008, just ahead of the implosion of Lehman Brothers that triggered a financial panic, the yield spread between the nominal less inflation-indexed 10-year Treasuries was falling sharply. That was a warning sign of trouble ahead. In early 2009, by contrast, this inflation forecast started trending higher, telling us that the worst had passed. When inflation expectations softened again in the spring of 2010, the shift sent a message that the economy faced new challenges. Later on in the year, when this market forecast hit bottom at the end of August 2010 and started climbing soon after, it represented a vote of confidence that the Fed’s newly announced QE2 monetary stimulus would have some traction in the economy. And earlier this year, when inflation expectations turned down again, starting in April, that was a sign that a new macro storm was lurking.

Today, the inflation forecast is under 2%, down from around 2.6% in early April. For the moment, however, the decline in the market’s inflation outlook has stabilized. If it holds, that’s an encouraging sign that the crowd thinks the economy won’t suffer a new recession. That’s hardly a forgone conclusion and so it’s reasonable to wonder if the stability is the real deal. Given the precarious state of macro these days, one can only wonder if the current tranquility in this indicator is the calm before the next leg of the storm. Or have we really hit bottom?

The answer, of course, will be determined by the economic updates as they arrive. Whatever comes, the inflation forecast via the Treasury market is likely to remain an early warning system of the next big change.
It’s worth noting that the stock market hit bottom earlier this week and has rallied sharply since a late-Wednesday rally. That could be noise, of course, but for the moment the sentiment has shifted toward optimism. It could all give way with one bad economic report, of course. The first test comes later today, when the government releases its September employment report.
Meanwhile, there’s ongoing anxiety over what happens next in Europe. But there’s a whiff of stability on the Continent too. “European stock indexes as well as shares in a number of sectors such as banking, insurance, oil, utilities and telecoms seem to be stabilizing,” says Vincent Guenzi of Cholet Dupont via Reuters this morning. “This stabilization may be a sign of a strong rebound to come if we get significant progress in the resolution of the euro zone debt crisis.”
Commodity prices are looking firmer too, with the asset class poised “for the first weekly advance in five, after European policy makers stepped up measures to contain the region’s debt crisis, boosting prospects for demand,” notes Bloomberg.
There was even some cautiously optimistic words from the CEO corner yesterday. “We don’t see a contraction; we don’t see a recession,” says the founder of FedEx. “It’s steady as you go, slow growth.” The head of GE agrees, opining that “recovery is underway, but it’s a long, slow recovery. Slower than we’d like,”
Maybe this is as bad as it gets; maybe not. At this point, it’s hard to be sure about anything. One discouraging number from the economic trenches could change everything. In any case, the market’s inflation forecast is likely to offer an early signal of the future. For now, steady as she goes.