Financial Market Update: Treasury Yields and Inflation Expectations or is it Sovereign Risk as Well?

Financial markets and the Fed recently have been focused on prospective inflation. The issue at the Fed stems from the approaching April Open Market Committee meeting and a determination as to whether or not its low interest rate policy is creating asset bubbles and future inflation. The financial markets are similarly worried about higher inflation and the prospects that it will drive bond prices downward and market yields upward as occurred recently when the ten year Treasury temporarily went over 4%.

The ten year Treasury breaking the 4% mark caused a controversy among policymakers inside the Fed as well as among those in the financial market that are pricing fixed income. There are several dimensions to the controversy. First, did the rising 10 year Treasury yield signal that the markets believed inflation is on our horizon? Second, press interviews revealed there were several methods by which one answers the prospective inflation question. Is inflation based on excess money or is it based on the gap between Actual GDP and Potential GDP? And lastly, the Treasury breaking 4% raised the question of whether the financial markets have come to price in the risk that the US government will be stretched to the limit to fund its prospective future government deficits.

There are numerous theories of inflation causation and hence there is a difference of opinion regarding future inflation even when all possess the same information. Typically the range of expected inflation can be characterized by a tight normal distribution around some single digit inflation rate typically very close to the previous year’s actual inflation rate. “This Time is Different” is not only a recent book concerning sovereign risk but the title is appropriate to much of what is occurring these days and is especially applicable to inflation expectations. The Wall Street Journal of April 16 reports (Fed is Expected to Keep Rates Low for Now) that a survey of economists on the question of immediate inflation risk, 23 believed inflation would accelerate and 23 believed a slowing of inflation was a bigger risk hence, a bifurcated distribution of expectations. Much the same is coming from the Fed as some Fed bank presidents believe in monetary based induced inflation and others believe in the GDP Gap based deflationary forces (including Bernanke) and both camps are going public to justify their voting on the matter of Fed Exit.

This range of expectations arises out of the differences in the basic understanding of the inflation generating process. Here we are more than 30 years since the highest peace-time inflation rates of the l970s which was an event seeking an explanation. Many converted to monetarism at the time which became a lifetime obsession of checking the money supply growth as an indication of future inflation so when in 2008 the Fed more than doubled the monetary base almost overnight, the perceived natural law of MV=PY (assuming V is constant) lead those with monetarists inclinations to believe that a doubling of prices was about to occur. At the same time there were a few brave souls who looked at the same facts and came to the conclusion that deflation lay ahead and fixed income bonds with long duration were a smart buy.

What this group saw was an alternative analysis of inflation that rested upon the Inflationary or Deflationary Gap analysis that originated with Art Okun in the l960s. The “Gap” is the difference between actual GDP spending and the GDP that could be produced without straining the existing inputs of labor and capital. The supply based GDP is called Potential GDP which is consistent with labor and capital utilization that does not drive the scarcity and the price of inputs and hence cause firms to raises prices. One beauty of the Gap analysis is that it addresses both the demand side in the Actual GDP number which includes monetary and other influences on spending as well as the supply side that is subject to many of its own nuances such as oil prices, productivity, and labor force growth and so on. Indeed, during the winter of 2008-2009 it was a brave forecaster and money manager who went long, long term Treasuries on the basis of this theory in the face of the unprecedented money base increase. Lacy Hunt of Hoisington and Gary Shilling come to mind that had the conviction and courage to do so and moreover they went public.

Output Gap (deviation of real GDP from real potential GDP)

Now more than a year later Treasury yields have been increasing which has rekindled the debate both in the central bank as in the market place. The WSJ front page story “Inflation Fears Cut Two Ways at the Fed” describes an “intensifying internal Fed debate over the behavior of inflation … as the central bank plots an exit from an unprecedented experiment in easy money.” The story does us the favor of displaying the GDP gap that the long bond faithful pin their hope on.

As can be seen Actual GDP is well below Potential GDP though the Gap is narrowing a tiny bit. However, the deflationary gap with Actual GDP below Potential GDP is the excess resource zone and for excess resources to go away would depend on the strength of the GDP recovery. On that subject there are extreme differences of opinion as to whether the recovery will be V, U or W shaped and a strong V is needed. Certainly the graph gives one the impression that we are years away from Actual GDP gaining the momentum to again penetrating Potential GDP and place the economy into the inflationary gap. None the less, markets price the anticipation of future events and if the rising 10 year Treasury yield is due to inflation expectations Mr. Market is getting a very early start. There is some precedent that has lasting effects. In the tech bust, an economic bottom occurred in 2002 and by May, 2003 inflation risk pricing returned to the 10 year Treasury market well in advance of the actual event.

Given all this optimism that a rebounding GDP will overrun Potential GDP there still are other credible reasons for long Treasury prices to decline. US sovereign risk is likely being priced given the contagion of Greece to all developed world sovereign debt. Furthermore, the recently passed health care legislation is also a candidate to have stirred concerns for the financing burden of Treasury debt and the potential for a monetization in future years. There are other credible explanations as well for the rising yield on the 10 year Treasury. A flight to quality among country sovereign debt yields occurred as the Greece problem drove capital to the US in early 2010. (Will 2009 Financial Market Trends Hold Up in 2010?)Some of that capital might be returning the Europe now that IMF support seems to be building for a Greece bailout. There is yet other mega shift explanation of the market yields rising. It could be an indication that the Chinese have become net sellers of Treasuries over the past four months and China’s bailout of the Treasury market has possibly run its course now that China is running a trade deficit and is facing normalization of exchange rates.

In any event if the financial market blips of this week are indeed the beginning of a trend to normalization of both the economy and financial markets and a sufficiently strong economy to generate inflation, fixed income managers need to have a plan as to what assets that conform to client mandates will not result in negative total returns. The alternatives would likely lay in short maturity debt that is rolled over as it matures which gives the money manager the ability to ride interest rates up without taking a market loss on principal. Other alternatives are floating rate debt or foreign debt from an environment that is not likely to inflate or face sovereign risk.

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