Deflation may or may not be coming, but the Treasury market’s forecast is clear.
After yesterday’s news of a sharp drop in consumer prices, which came on the heels of something similar in wholesale prices the day before, traders in government securities took the hint. Yesterday’s closing yield of 3.391% for the benchmark 10-year Treasury isn’t the lowest we’ve seen, but it’s getting close.
Back in June 2003, the 10-year briefly dipped to the then-astounding low of just under 3.10%. At the time, some observers of the financial scene said the trough would stand for generations as a low-water mark. A reasonable call at the time, based on the available information. But the forecast has been abandoned in light of recent trends, and rightly so.
The economic news of late gives reason to think that the 2003 low may soon give way. In the current environment, any news of weakening demand promotes the expectation that prices generally will fade for the foreseeable future. The latest example comes in this morning’s update on initial jobless claims, which jumped again last week, rising to 542,000, the highest since 1992. The message in this leading indicator is clear: the labor market will continue to shed jobs. Unfortunately, there’s a surplus of similarly discouraging trends in everything from retail sales to manufacturing activity. Pricing power, as a result, becomes weaker by the day, and the shift is quickly finding traction in interest rates, as recent changes in the Treasury yield curve remind.

No wonder, then, that the inflation forecast coming out of the Treasury market has crashed. As of last night’s close, the 10-year forecast for inflation was an annualized 0.4%, based on the yield spread between the nominal and inflation-indexed 10-year Treasury (see chart below). As recently as October 22, this inflation outlook was over 1% and just this past July it was above 2%.

The change in the state of economic and financial affairs in the past year or so–the past two months!–has been extraordinary, perhaps unprecedented in the modern age in terms of the pace and depth of the reversal. The magnitude of the change suggests that the recovery will be slow in coming and even then the rebound may be weak for an extended period. The smoking gun for this prediction comes via the generally high level of indebtedness among consumers. Leading the charge is the still-sinking real estate market, which continues to pressure household finances. The burden, already heavy, will be even more onerous if and when deflation arrives in earnest.

The main threat in all of this is that the financial pain becomes negatively self reinforcing. The elevated challenge of paying off debts convinces consumers to steer clear of the shopping malls, which in turn weighs heavily on economic growth, which contributes to job destruction, which pushes prices lower, which makes debt servicing tougher, and round and round we go.
How do we stop this toxic merry go round? As we’ve discussed, the monetary solution is spent. Effective Fed funds (a more realistic measure of actual banking transactions) is now at 0.37%, even though the more widely quoted Target Fed funds rate is 1.0%. With the central bank within shouting distance of zero, fiscal stimulus via Congress is the only game left. Accordingly, the economy’s fate seems to rest ever more firmly in the hands of the politicians. That’s less than encouraging for all the usual reasons that go with waiting and hoping for a Washington-based rescue. What’s more, the U.S. is knee-deep in a government transition, which raises an additional layer of uncertainty over the usual political questions.
The silver lining is that the bargain prices for strategic-minded investors will be astonishing in the months (years?) to come–even beyond the already rich valuations on offer as we write. The question is whether anyone will have the stomach for partaking in the plush bargains that await.