Tuesday, June 22, 2010

Bond Markets Not Signalling Rise In U.S. Inflation

According to a Bloomberg report, as webbed by Business Week, bond market inflation expectations are lowering. Those expectations, measured by the yield gap between five-year Treasuries and TIPS, comp out at 1.69%. This number is significantly lower than the result gleaned by the Thomson Reuters/University of Michigan confidence survey; that number is 2.7% inflation in five years. Both have lowered in the last two months.

As a result, it's unlikely that the Fed will even hint at raising the Fed Funds rate when the FOMC meeting ends tomorrow. Ben Bernanke, in his puzzlement remark, suggested he's not taking gold into consideration as much as other commodities. The lowering of expectations is going to dampen the credibility of the FOMC's inflation hawks.

The article mentions that gold is acting more as a hedge against currency instability. Of course, gold is also acting as a safe haven against sovereign default. The question continues to be, is gold also anticipating future inflation that the bond market isn't?

It's a tough call. The supposed bond vigilantes have been asleep; had they been the force to be reckoned with which they were in the 1980s, real rates would have never gone negative. Short rates are negative now. The sub-1-year rates that have already been booked have been below the rate of inflation in the same timeframe, leading to realized negative real rates of return. So, it can't be said that fixed-income investors are leaning on the U.S. Treasury.

The current 5-year T-note rate is 2.00%. Given expectations and inflation norms, that rate offers about a zero real return. Whatever is exciting the bond vigilantes - if anything - it's not future inflation. Perhaps they've disbanded.

On the other hand, gold's continued advance is compatible with rising inflation, even though other commodities aren't following through right now. In part, that's because commodities outpaced gold last year in percentage terms. Also, industrial metals aren't just geared towards inflation; they won't act as if they were unless inflation becomes serious enough to overwhelm demand droppage due to slowdown expectations. The excess reserves are still out there, even if they're not acting to increase the money supply.

It's hard to see what the inflation picture is going to be. Taking a compromise approach says that inflation wil be dormant in the near term but will pick up later.

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